tradeoff between inflation and · pdf filethe cost of reducing inflation ... short run and the...

1

The Short-RunTradeoff betweenInflation andUnemployment

Chapter 33

Copyright © 2001 by Harcourt, Inc.

All rights reserved. Requests for permission to make copies of any part of thework should be mailed to:

Permissions Department, Harcourt College Publishers,6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Unemployment and Inflation

u The natural rate of unemploymentdepends on various features of thelabor market.

u Examples include minimum-wage laws,the market power of unions, the role ofefficiency wages, and the effectivenessof job search.



u The inflation rate depends primarilyon growth in the quantity of money,controlled by the Fed.

u The misery index, one measure of the“health” of the economy, adds togetherthe inflation rate and unemploymentrate.

2



u Society faces a short-run tradeoff betweenunemployment and inflation.

u If policymakers expand aggregate demand, they can lower unemployment,but only at the cost of higher inflation.

u If they contract aggregate demand, theycan lower inflation, but at the cost of temporarily higher unemployment.


The Phillips Curve

The Phillips curve illustrates theshort-run relationship betweeninflation and unemployment.


The Phillips Curve...

UnemploymentRate (percent)

0

InflationRate

(percentper year)

4

B6

A

7

2

Phillips curve

3


Aggregate Demand, AggregateSupply, and the Phillips Curve

u The Phillips curve shows the short-runcombinations of unemployment andinflation that arise as shifts in theaggregate demand curve move theeconomy along the short-run aggregatesupply curve.


Aggregate Demand, AggregateSupply, and the Phillips Curve

u The greater the aggregate demand forgoods and services, the greater is theeconomy’s output, and the higher is theoverall price level.

u A higher level of output results in a lowerlevel of unemployment.


How the Phillips Curve is Related to the Modelof Aggregate Demand and Aggregate Supply...

Phillips curve

0

(b) The Phillips Curve

Inflation Rate(percent per

year)


0

(a) The Model of AD and AS

Price Level

Low AD

High AD

B

4

6

(output is8,000)

A

7

2

(output is7,500)

A

7,500

102

(unemploymentis 7%)

B

8,000

106

(unemploymentis 7%)

Short-runAS

4


Shifts in the Phillips Curve:The Role of Expectations

The Phillips curve seems to offerpolicymakers a menu of possibleinflation and unemployment outcomes.


The Long-Run Phillips Curve

u In the 1960s, Friedman and Phelpsconcluded that inflation andunemployment are unrelated in the longrun.u As a result, the long-run Phillips curve is

vertical at the natural rate of unemployment.

u Monetary policy could be effective in theshort run but not in the long run.


The Long-Run Phillips Curve...

UnemploymentRate0 Natural rate of

unemployment

InflationRate Long-run

Phillips curve

BHigh

inflation1. When theFed increasesthe growthrate of themoneysupply, therate ofinflationincreases…

2. … butunemploymentremains at itsnatural ratein the long run.ALow

inflation

5

Natural rate ofunemployment

Long-run Phillipscurve

0


InflationRate

A

Natural rate ofoutput

0

P1

Aggregatedemand, AD1

Long-run aggregatesupply

(a) The Model of AggregateDemand and Aggregate Supply

PriceLevel

4. …but leaves output and unemploymentat their natural rates.

How the Phillips Curve is Related to theModel of Aggregate Demand andAggregate Supply…

P2

2. …raises theprice level…

Quantity of Output

Unemploy-ment Rate

1. An increase in themoney supply increasesaggregate demand…

AD2

B

3. …andincreases theinflation rate…



Expectations and theShort-Run Phillips Curve

Expected inflation measureshow much people expect theoverall price level to change.



u In the long run, expected inflation adjuststo changes in actual inflation.

u The Fed’s ability to create unexpectedinflation exists only in the short run.u Once people anticipate inflation, the only

way to get unemployment below the naturalrate is for actual inflation to be above theanticipated rate.

6



UnemploymentRate =


Actual Expectedinflation inflation

-( )a-

This equation relates the unemployment rateto the natural rate of unemployment, actual

inflation, and expected inflation.

How Expected Inflation Shifts theShort-Run Phillips Curve...

UnemploymentRate

0 Natural rate ofunemployment

Inflation Rate

CB

Long-runPhillips curve

A

Short-run Phillips curve withhigh expected inflation

Short-run Phillips curve withlow expected inflation

1. Expansionarypolicy movesthe economy upalong the short-run Phillipscurve...

2. …but in the long-run,expected inflation rises,and the short-run Phillipscurve shifts to the right.



The Natural-Rate Hypothesis

u The view that unemploymenteventually returns to its natural rate,regardless of the rate of inflation, iscalled the natural-rate hypothesis.

u Historical observations support thenatural-rate hypothesis.

7


The Natural Experiment for theNatural Rate Hypothesis

u The concept of a stable Phillips curvebroke down in the in the early ’70s.

u During the ’70s and ’80s, the economyexperienced high inflation and high unemployment simultaneously.


The Phillips Curve in the 1960s...

Unemployment Rate (percent)

Inflation Rate(percent per year)

0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

1968

1966

19611962

1963

1967

1965 1964


The Breakdown of the Phillips Curve...



0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

197319711969

19701968

1966

19611962

1963

1967

1965 1964

1972

8


Shifts in the Phillips Curve:The Role of Supply Shocks

u Historical events have shown that theshort-run Phillips curve can shift due tochanges in expectations.



u The short-run Phillips curve also shiftsbecause of shocks to aggregate supply.u Major adverse changes in aggregate supply

can worsen the short-run tradeoff betweenunemployment and inflation.

u An adverse supply shock gives policymakersa less favorable tradeoff between inflationand unemployment.



u A supply shock is an event that directlyaffects firms’ costs of production andthus the prices they charge.

u It shifts the economy’s aggregatesupply curve...

u … and as a result, the Phillips curve.

9


AS2

1. An adverseshift in aggregatesupply…

An Adverse Shock to AggregateSupply...

Quantity of Output

0

PriceLevel

P1Aggregate

demand


Unemployment Rate0


A

InflationRate

Phillips curve, PC1

Aggregatesupply, AS1

A

Y1

P2

3. …and raises theprice level…

B

2. …lowers output…

Y2

B

4. …giving policymakersa less favorable tradeoffbetween unemploymentand inflation.

PC2



u In the 1970s, policymakers faced twochoices when OPEC cut output andraised worldwide prices of petroleum.u Fight the unemployment battle by expanding

aggregate demand and accelerate inflation.

u Fight inflation by contracting aggregatedemand and endure even higherunemployment.




0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

The Supply Shocks of the 1970s...

1972

19751981

1976

19781979

1980

1973

1974

1977

10


The Cost of Reducing Inflation

u To reduce inflation, the Fed has to pursuecontractionary monetary policy.

u When the Fed slows the rate of moneygrowth, it contracts aggregate demand.

u This reduces the quantity of goods andservices that firms produce.

u This leads to a rise in unemployment.

A

Short-run Phillips curvewith high expected

inflation

1. Contractionary policymoves the economydown along the short-runPhillips curve...

UnemploymentRate



Phillips curve

CB

Short-run Phillips curvewith low expected

inflation

2. ... but in the long run, expected inflation fallsand the short-run Phillips curve shifts to the left.

Disinflationary Monetary Policy in theShort Run and the Long Run...




u To reduce inflation, an economy mustendure a period of high unemploymentand low output.u When the Fed combats inflation, the

economy moves down the short-run Phillipscurve.

u The economy experiences lower inflation butat the cost of higher unemployment.

11



u The sacrifice ratio is the number ofpercentage points of annual output that islost in the process of reducing inflationby one percentage point.u An estimate of the sacrifice ratio is five.

u To reduce inflation from about 10% in1979-1981 to 4% would have required an estimated sacrifice of 30% of annual output!


Rational Expectations

The theory of rational expectationssuggests that people optimally use allthe information they have, includinginformation about government policies,when forecasting the future.



u Expected inflation explains why there is atradeoff between inflation andunemployment in the short run but not inthe long run.

u How quickly the short-run tradeoffdisappears depends on how quicklyexpectations adjust.

12



u The theory of rational expectationssuggests that the sacrifice-ratio could bemuch smaller than estimated.


The Volcker Disinflation

u When Paul Volcker was Fed chairman inthe 1970s, inflation was widely viewed asone of the nation’s foremost problems.

u Volcker succeeded in reducing inflation(from 10% to 4%), but at the cost of highemployment (about 10% in 1983).




0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

The Volcker Disinflation...

1979

1980

1983

1981

1982

1984

1986

19871985

A

B

C

13


The Greenspan Era

u Alan Greenspan’s term as Fed chairmanbegan with a favorable supply shock.u In 1986, OPEC members abandoned their

agreement to restrict supply.

u This led to falling inflation and fallingunemployment.



0 1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


The Greenspan Era...

19841991

19851992

19931986

1994

19881987

1995

19891990


The Greenspan Era

u Fluctuations in inflation andunemployment in recent years have beenrelatively small due to the Fed’s actions.

14


Summaryu The Phillips curve describes a negative

relationship between inflation andunemployment.

u By expanding aggregate demand,policymakers can choose a point on thePhillips curve with higher inflation and lowerunemployment.

u By contracting aggregate demand,policymakers can choose a point on thePhillips curve with lower inflation and higherunemployment.


Summary

u The tradeoff between inflation andunemployment described by the Phillipscurve holds only in the short run.

u The long-run Phillips curve is vertical atthe natural rate of unemployment.


Summary

u The short-run Phillips curve also shiftsbecause of shocks to aggregate supply.

u An adverse supply shock givespolicymakers a less favorable tradeoffbetween inflation and unemployment.

15


Summary

u When the Fed contracts growth in themoney supply to reduce inflation, itmoves the economy along the short-runPhillips curve.

u This results in temporarily highunemployment.

u The cost of disinflation depends on howquickly expectations of inflation fall.


Summary

u Because monetary and fiscal policy caninfluence aggregate demand, thegovernment sometimes uses these policyinstruments in an attempt to stabilize theeconomy.

u Changes in attitudes by households andfirms shift aggregate demand; if thegovernment does not respond, the result isundesirable and unnecessary fluctuations in output and employment.


GraphicalReview

16


The Phillips Curve...


0

InflationRate

(percentper year)

4

B6

A

7

2

Phillips curve


How the Phillips Curve is Related to the Modelof Aggregate Demand and Aggregate Supply...

Phillips curve

0


Inflation Rate(percent per

year)


0

(a) The Model of AD and AS

Price Level

Low AD

High AD

B

4

6

(output is8,000)

A

7

2

(output is7,500)

A

7,500

102

(unemploymentis 7%)

B

8,000

106

(unemploymentis 7%)

Short-runAS


The Long-Run Phillips Curve...

UnemploymentRate0 Natural rate of

unemployment


Phillips curve

BHigh

inflation1. When theFed increasesthe growthrate of themoneysupply, therate ofinflationincreases…

2. … butunemploymentremains at itsnatural ratein the long run.ALow

inflation

17

How the Phillips Curve is Related to theModel of Aggregate Demand andAggregate Supply…


Long-run Phillipscurve

0


InflationRate

A

Natural rate ofoutput

0

P1

Aggregatedemand, AD1

Long-run aggregatesupply


PriceLevel

4. …but leaves output and unemploymentat their natural rates.

P2

2. …raises theprice level…

Quantity of Output

Unemploy-ment Rate

1. An increase in themoney supply increasesaggregate demand…

AD2

B

3. …andincreases theinflation rate…


How Expected Inflation Shifts theShort-Run Phillips Curve...

UnemploymentRate


Inflation Rate

CB

Long-runPhillips curve

A

Short-run Phillips curve withhigh expected inflation

Short-run Phillips curve withlow expected inflation

1. Expansionarypolicy movesthe economy upalong the short-run Phillipscurve...

2. …but in the long-run,expected inflation rises,and the short-run Phillipscurve shifts to the right.



The Phillips Curve in the 1960s...



0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

1968

1966

19611962

1963

1967

1965 1964

18


The Breakdown of the Phillips Curve...



0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

197319711969

19701968

1966

19611962

1963

1967

1965 1964

1972


An Adverse Shock to AggregateSupply...

AS2

1. An adverseshift in aggregatesupply…

Quantity of Output

0

PriceLevel

P1Aggregate

demand


Unemployment Rate0


A

InflationRate

Phillips curve, PC1

Aggregatesupply, AS1

A

Y1

P2

3. …and raises theprice level…

B

2. …lowers output…

Y2

B

4. …giving policymakersa less favorable tradeoffbetween unemploymentand inflation.

PC2


The Supply Shocks of the 1970s...Inflation Rate

(percent per year)


0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

1972

19751981

1976

19781979

1980

1973

1974

1977

19

A

Short-run Phillips curvewith high expected

inflation

1. Contractionary policymoves the economydown along the short-runPhillips curve...

UnemploymentRate



Phillips curve

CB

Short-run Phillips curvewith low expected

inflation

2. ... but in the long run, expected inflation fallsand the short-run Phillips curve shifts to the left.

Disinflationary Monetary Policy in theShort Run and the Long Run...



The Volcker Disinflation...



0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

1979

1980

1983

1981

1982

1984

1986

19871985

A

B

C


The Greenspan Era...


0 1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


19841991

19851992

19931986

1994

19881987

1995

19891990

tradeoff between inflation and · pdf filethe cost of reducing inflation ... short run and the...

Documents