Lecture Principles of economics - Chapter 35: The short-run tradeoff between inflation and unemployment

In this chapter we examine this tradeoff more closely. The relationship between inflation and unemployment is a topic that has attracted the attention of some of the most important economists of the last half century. The best way to understand this relationship is to see how thinking about it has evolved over time.

The Short-Run Tradeoff between Inflation and Unemployment Copyright © 2004 South-Western 35 Unemployment and Inflation  • The natural rate of unemployment depends on  various features of the labor market • Examples include minimum­wage laws, the  marketpowerofunions,theroleofefficiency wages,andtheeffectivenessofjobsearch ã Theinflationratedependsprimarilyongrowth inthequantityofmoney,controlledbytheFed Copyright â 2004 South-Western Unemployment and Inflation • Society faces a short­run tradeoff between  unemployment and inflation • If policymakers expand aggregate demand, they  can lower unemployment, but only at the cost  of higher inflation • If they contract aggregate demand, they can  lower inflation, but at the cost of temporarily  higher unemployment Copyright © 2004 South-Western THE PHILLIPS CURVE • The Phillips curve illustrates the short­run  relationship between inflation and  unemployment Copyright © 2004 South-Western Figure The Phillips Curve Inflation Rate (percent per year) B A Phillips curve Unemployment Rate (percent) Copyright © 2004 South-Western Aggregate Demand, Aggregate Supply, and the Phillips Curve ã ThePhillipscurveshowstheshortưrun combinationsofunemploymentandinflation thatariseasshiftsintheaggregatedemand curvemovetheeconomyalongtheshortưrun aggregatesupplycurve Copyright â 2004 South-Western Aggregate Demand, Aggregate Supply, and the Phillips Curve • The greater the aggregate demand for goods  and services, the greater is the economy’s  output, and the higher is the overall price level • A higher level of output results in a lower level  of unemployment Copyright © 2004 South-Western Figure How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level 102 Inflation Rate (percent per year) Short-run aggregate supply B 106 B A High aggregate demand Low aggregate demand (b) The Phillips Curve 7,500 8,000 (unemployment (unemployment is 7%) is 4%) Quantity of Output A Phillips curve (output is 8,000) Unemployment (output is Rate (percent) 7,500) Copyright © 2004 South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS ã ThePhillipscurveseemstoofferpolicymakers amenuofpossibleinflationandunemployment outcomes Copyright â 2004 South-Western The Long-Run Phillips Curve • In the 1960s, Friedman and Phelps concluded  that inflation and unemployment are unrelated  in the long run • As a result, the long­run Phillips curve is vertical at  the natural rate of unemployment • Monetary policy could be effective in the short run  but not in the long run Copyright © 2004 South-Western Figure 10 Disinflationary Monetary Policy in the Short Run and the Long Run Inflation Rate Long-run Phillips curve Contractionary policy moves the economy down along the short-run Phillips curve A Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation Unemployment Natural rate of unemployment but in the long run, expected Rate inflation falls, and the short-run Phillips curve shifts to the left Copyright © 2004 South-Western THE COST OF REDUCING INFLATION • To reduce inflation, an economy must endure a  period of high unemployment and low output • When the Fed combats inflation, the economy  moves down the short­run Phillips curve • The economy experiences lower inflation but at the  cost of higher unemployment Copyright © 2004 South-Western THE COST OF REDUCING INFLATION • The sacrifice ratio is the number of percentage  points of annual output that is lost in the  process of reducing inflation by one percentage  point • An estimate of the sacrifice ratio is five • To reduce inflation from about 10% in  1979­1981  to 4% would have required an estimated sacrifice of  30% of annual output! Copyright © 2004 South-Western Rational Expectations and the Possibility of Costless Disinflation • The theory of rational expectations suggests  that people optimally use all the information  they have, including information about  government policies, when forecasting the  future Copyright © 2004 South-Western Rational Expectations and the Possibility of Costless Disinflation • Expected inflation explains why there is a  tradeoff between inflation and unemployment  in the short run but not in the long run • How quickly the short­run tradeoff disappears  depends on how quickly expectations adjust Copyright © 2004 South-Western Rational Expectations and the Possibility of Costless Disinflation ã Thetheoryofrationalexpectationssuggests thatthesacrificeưratiocouldbemuchsmaller thanestimated Copyright â 2004 South-Western The Volcker Disinflation • When Paul Volcker was Fed chairman in the  1970s, inflation was widely viewed as one of  the nation’s foremost problems • Volcker succeeded in reducing inflation (from  10 percent to 4 percent), but at the cost of high  employment (about 10 percent in 1983) Copyright © 2004 South-Western Figure 11 The Volcker Disinflation Inflation Rate (percent per year) 10 A 1980 1981 1979 1982 1984 1987 C 2 B 1983 1985 1986 10 Unemployment Rate (percent) Copyright © 2004 South-Western The Greenspan Era • Alan Greenspan’s term as Fed chairman began  with a favorable supply shock.  • In 1986, OPEC members abandoned their  agreement to restrict supply • This led to falling inflation and falling  unemployment Copyright © 2004 South-Western Figure 12 The Greenspan Era Inflation Rate (percent per year) 10 1990 1991 1989 1984 1988 1985 1987 2001 1995 1992 2000 1986 1997 1994 1993 1999 2002 1998 1996 2 10 Unemployment Rate (percent) Copyright © 2004 South-Western The Greenspan Era ã Fluctuationsininflationandunemploymentin recentyearshavebeenrelativelysmalldueto theFedsactions Copyright â 2004 South-Western Summary • The Phillips curve describes a negative  relationship between inflation and  unemployment • By expanding aggregate demand, policymakers  can choose a point on the Phillips curve with  higher inflation and lower unemployment • By contracting aggregate demand,  policymakerscanchooseapointonthePhillips curvewithlowerinflationandhigher unemployment Copyright â 2004 South-Western Summary ã Thetradeoffbetweeninflationand unemploymentdescribedbythePhillipscurve holdsonlyintheshortrun ã ThelongưrunPhillipscurveisverticalatthe naturalrateofunemployment Copyright â 2004 South-Western Summary • The short­run Phillips curve also shifts because  of shocks to aggregate supply • An adverse supply shock gives policymakers a  less favorable tradeoff between inflation and  unemployment Copyright © 2004 South-Western Summary • When the Fed contracts growth in the money  supply to reduce inflation, it moves the  economy along the short­run Phillips curve • This results in temporarily high unemployment • The cost of disinflation depends on how  quickly expectations of inflation fall Copyright © 2004 South-Western ... 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