Download Chapter 32 Inflation and Growth: The Phillips Curve

Chapter 32
Inflation and Growth: The Phillips
Curve
1.
When unemployment and inflation were both falling in the 1990s, it was because aggregate supply
was increasing at an unusually rapid rate-in response to a series of favorable supply shocks (low
oil prices, advances in technology, strong U.S. dollar). This extraordinary economic performance
does not contradict the basic trade-off between unemployment and inflation; favorable supply
shocks should produce rapid economic growth with falling inflation.
2.
In the long run, the aggregate supply curve and the Phillips curve are vertical. Therefore it is true
that the effects of fiscal and monetary policy upon output are temporary, if they move output away
from its natural or full employment level. It is also true that a recession is temporary; the economy
will eventually self-adjust automatically back to full employment. This does not imply, however,
that it is useless to use fiscal and monetary policy to shorten recessions. It may take a very long
time for an economy in recession to self-adjust back to full employment. Expansionary fiscal and
monetary policy can raise aggregate demand and restore full employment faster.
3.
Decisions about changing aggregate demand depend partly upon objective criteria, such as the
shape of the short-run Phillips curve and the time it takes the economy to self-adjust. They also
depend, however, upon political and value judgments - such as whether one fears the costs of
unemployment more than the costs of inflation. And of course, “fiscal and monetary policy” are
not just one thing. Different policies can have the same effect on aggregate demand, but very
different effects on income distribution and the composition of output; these are issues over which
there are usually serious political disagreements.
4.
A Phillips curve shows the trade-off between unemployment and inflation. When one is high, the
other is low. During the period 1954-1969, shifts in aggregate demand led to an inverse relationship
between unemployment and inflation. But during the 1970s, reductions in aggregate supply led to
the collapse of the Phillips curve, as both unemployment and inflation rose.
5.
Labor and management bargain over money wages, but one suspects that they really care more
about real wages, that is, money wages corrected for changes in the price level. If workers expect
rapid inflation in the future, they will demand higher money wages, to protect their purchasing
power. If management expects to be able to sell output for higher prices in the future, it will be
willing to grant higher wages.
6. Rational expectations are forecasts of inflation that make optimal use of all relevant
available information. If people’s expectations are rational, they will sometimes make
mistakes in forecasting inflation, but they will not systematically underpredict inflation.
The forecasting errors will be random, centering around the true value. The positively
sloped aggregate supply curve and the negatively sloped Phillips curve are based on the
assumption that when prices rise, wages and other costs lag behind. But the rational
expectations school denies that they will necessarily lag; rather, any differences between
wage and price increases will be random. Therefore, even the short-run aggregate
supply and Phillips curves are vertical. The only events that could shift output away from
its natural level are unexpected events, for example, completely unpredicted government
policy. The stunning implications of the rational expectations theory are, therefore, that
output and unemployment will not depart from their natural rates, and that government
policy cannot change output and unemployment, even temporarily, unless they are
unexpected. Believers in rational expectations do not favor fighting recessions with
expanded aggregate demand because, since the aggregate supply curve is vertical, the
economy is seldom below its natural level, and furthermore, increased aggregate
demand will cause only inflation, not more output. They do, however, favor fighting
inflation by cutting aggregate demand. Since output will not change, the full impact of the
demand cut will be on reducing inflation, and there will be no increase in unemployment
at all.
7.
Figure 32-1 shows that when the aggregate supply curve is vertical, shifting aggregate demand
curves change the price level, but do not change output. Belief in rational expectations leads to the
assertion that the aggregate supply curve is vertical, and that therefore changes in aggregate
demand affect only inflation, not unemployment.
FIGURE 32-1
8.
Answers to this question can reveal the students’ expectations of inflation. At a nominal interest
rate of 5 percent, the real interest rate depends upon what the students think future inflation will be.
If they predict 3 percent inflation, the real interest rate is 2 percent, while if they predict 4 percent
inflation, the real rate is 1 percent, etc. A person predicting 3 percent inflation would prefer a bond
indexed at a real rate of 3 percent to a non-indexed 5 percent bond, but would not prefer a bond
indexed at a real rate of 2 percent (and would certainly not prefer a bond indexed at a real rate of 1
percent). The higher the expected rate of inflation, the lower the rate on an indexed bond a person
would be willing to accept.
9.
The president may have worried that Greenspan would keep a tight check on the money supply, in
order to squelch the inflationary potential of the economy, while the president would have
preferred a more expansive monetary policy that would have brought unemployment lower.
10. (a) Expansionary fiscal policy was appropriate, to stimulate growth in real GDP and reduce
unemployment. Expansionary monetary policy would also help to stimulate real GDP and
reduce unemployment without an adverse impact on the federal deficit.
(b) The budget is in deficit and inflation is close to 3 percent so contractionary fiscal policy would
reduce the deficit and keep inflation in check. Similarly, contractionary monetary policy would
keep inflation in check but possibly increase the deficit as interest rates rise. The real concern
was that the growth rate of the economy would become too stagnant.
(c) Students will differ. The actual choice in Washington, D.C. was expansionary fiscal policy, to
stimulate the economy, coupled with mildly expansive monetary policy.