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R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
FIFTH EDITION
© 2015 Pearson Education, Inc..
CHAPTER
CHAPTER
17
Inflation, Unemployment,
and Federal Reserve Policy
Chapter Outline and
Learning Objectives
17.1 The Discovery of the ShortRun Trade-off between
Unemployment and Inflation
17.2 The Short-Run and LongRun Phillips Curves
17.3 Expectations of the Inflation
Rate and Monetary Policy
17.4 Federal Reserve Policy from
the 1970s to the Present
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The Discovery of the Short-Run Trade-off between
Unemployment and Inflation
17.1 LEARNING OBJECTIVE
Describe the Phillips curve and the nature of the short-run trade-off between
unemployment and inflation.
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Unemployment and Inflation
The two great
macroeconomic problems
that the Fed deals with (in
the short run) are
unemployment and
inflation.
But these two are related
in an important way:
higher levels of inflation
are associated with lower
levels of unemployment,
and vice versa.
Figure 17.1
The Phillips curve
This relationship is known as the Phillips curve, after economist
A.W. Phillips, the first to identify this relationship.
Phillips curve: A curve showing the short-run relationship between
the unemployment rate and the inflation rate.
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Why Does the Phillips Curve Exist?
In the AD-AS model, a small aggregate demand
Figure 17.2
increase leads to low inflation and high unemployment. Using aggregate
and
A stronger AD increase results in lower unemployment demand
aggregate supply
but more inflation—the short run Phillips curve
analysis to explain
the Phillips curve
relationship.
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Is the Phillips Curve a Policy Menu?
During the 1960s, some economists argued that the Phillips curve
was a structural relationship: a relationship that depends on the
basic behavior of consumers and firms, and that remains unchanged
over long period.
• In the 1960s, this relationship had appeared to be quite stable.
If this was true, policy-makers could choose a point on the curve:
trading permanently higher inflation for lower unemployment, or vice
versa.
• But this turned out not to be true: allowing more inflation doesn’t
lead to permanently lower unemployment.
• That is, the short-run Phillips curve moves over time.
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The Long-Run Phillips Curve
By the late 1960s,
most economists
agreed that the
long-run aggregate
supply curve was
vertical.
• Is a vertical
long-run AS
curve
compatible with
a downwardsloping long-run
Figure 17.3a A vertical long-run aggregate supply curve
Phillips curve?
means a vertical long-run Phillips curve
Economists Milton Friedman and Edmund Phelps argued that this
implied the long-run Phillips curve was also vertical: in the long run,
employment is determined by output, which in the long run does not
depend on the price level.
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Natural Rate of Unemployment
Since employment was
determined by potential GDP,
so must be unemployment.
• Unemployment, in the long
run, goes to its natural rate,
when the output returns to
potential GDP.
Natural rate of
unemployment: The
unemployment rate that exists
when the economy is at
Figure 17.3b
potential GDP.
A vertical long-run aggregate supply curve
means a vertical long-run Phillips curve
At this output level, there is no cyclical unemployment; but there
does remain structural and frictional unemployment. These latter
two are not predictably affected by inflation.
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The Role of Expectations of Future Inflation
However this conclusion contradicted the experience of the 1950s
and 1960s, during which time a stable trade-off seemed to exist
between unemployment and inflation.
• The short-run trade-off appears to exist because workers and firms
sometimes expect the inflation rate to be either higher or lower
than it turns out to be.
Suppose Ford and the United Auto Workers (UAW) agree to a wage
of $34.65 per hour for 2016. They expect the price level to increase
from 110.0 in 2015 to 115.5 in 2015: 5% inflation.
• Then $34.65 represents a real wage of $30.00:
Real wage 
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Nominal wage
$34.65
 100 
 100  $30
Price level
105
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The Role of Expectations of Future Inflation—cont.
Nominal Wage Expected Real Wage
$34.65
Actual Real Wage
Expected P2016 = 115.5
Actual P2016 = 112.2
Actual P2016 = 118.8
Expected inflation = 5%
Actual inflation = 2%
Actual inflation = 8%
$34.65
$34.65
$34.65
 100  $29.17
 100  $30.00
 100  $30.88
108
105
102
Table 17.1
The effect of unexpected price level
changes on the real wage
If the expectations about inflation are correct, the real wage will be
$30 as expected; Ford will hire its planned number of workers. But:
If…
then…
actual inflation is greater
than expected inflation,
the actual real wage is less
than the expected real wage
the unemployment rate falls
actual inflation is less
than expected inflation
the actual real wage is greater
than the expected real wage
the unemployment rate rises
and...
Table 17.2
The basis for the short-run Phillips curve
Friedman: “There is always a temporary trade-off between inflation and
unemployment; there is no permanent trade-off. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation.”
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Making
the
Connection
Do Workers Understand Inflation?
Most economists believe an
increase in inflation will
quickly lead to an increase in
wages.
• However workers tend not
to believe this, expecting
that inflation will decrease
their purchasing power for
years, or even
permanently.
This has an important consequence: since workers do not expect
their wages to increase with inflation, firms can increase wages by
less than inflation (i.e. decrease real wages) without worrying about
workers quitting or their morale falling.
• This gives a further reason why higher inflation will lead to lower
(short-run) unemployment.
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The Short-Run and Long-Run Phillips Curves
17.2 LEARNING OBJECTIVE
Explain the relationship between the short-run and long-run Phillips curves.
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The Phillips Curves in the 1960s
Throughout the early 1960s,
inflation was low—about
1.5%.
Firms and workers expected
this rate to continue, but
inflation was higher in the late
1960s, about 4.5%, due to
expansionary monetary and
fiscal policies.
• Because this was
unexpected, the economy
moved along the short-run
Phillips curve, resulting in
low unemployment of 3.5%.
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Figure 17.4
The short-run Phillips
curve of the 1960s and
the long-run Phillips curve
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Shifts in the Short-Run Phillips Curve
Eventually, firms and workers
adjusted their expectations to
the inflation rate of 4.5%.
• Workers demanded higher
wages to compensate for the
increased inflation, and the
economy returned to potential
GDP, with unemployment at its
natural rate of 5%.
The “new normal” inflation rate of
4.5% became embedded in the
economy, in the form of the shortrun Phillips curve shifting to the
right. 3.5% unemployment would
require another unexpected
increase in the rate of inflation.
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Figure 17.5
Expectations and the
short-run Phillips curve
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A Short-Run Phillips Curve for Every Expected Inflation Rate
Each expected
inflation rate generates
a different short-run
Phillips curve.
In each case, when
the inflation rate is
actually at the
expected level, the
unemployment level is
at its natural rate—i.e.
the long-run Phillips
curve.
Figure 17.6
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A short-run Phillips
curve for every
expected inflation rate
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Implications for Monetary Policy
By the 1970s, most
economists agreed that the
long-run Phillips curve was
vertical; it was not possible to
“buy” a permanently lower
unemployment rate at the cost
of permanently higher inflation.
• In order to keep
unemployment lower than
the natural rate, the Fed
would need to continually
increase inflation.
• Or it could decrease
inflation, at the cost of a
temporarily higher
unemployment rate.
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Figure 17.7
The inflation rate and the
natural rate of unemployment
in the long run
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Implications for Monetary Policy
Since any rate of
unemployment other
than the natural rate
results in the rate of
inflation increasing or
decreasing, the natural
rate of unemployment is
sometimes referred to as
the non-accelerating
inflation rate of
unemployment, or
NAIRU.
Figure 17.7
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The inflation rate and the
natural rate of unemployment
in the long run
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Making
the
Does the Natural Rate of Unemployment Ever Change?
Connection
The natural rate of
unemployment might change
if the amount of frictional or
structural unemployment
changed. Possible reasons
for this include:
Demographic changes:
younger and less skilled
workers have higher
unemployment rates.
Changes in labor market institutions: a change in the availability
of unemployment insurance, the prevalence of unions, or legal
barriers to firing workers.
Past high rates of unemployment: during long periods of
unemployment, workers’ skills may deteriorate, or they may
become dependent on the government for support.
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Expectations of the Inflation Rate and Monetary Policy
17.3 LEARNING OBJECTIVE
Discuss how expectations of the inflation rate affect monetary policy.
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How Long Does It Take to Get to the Long Run?
How long can the economy remain off the long-run Phillips curve?
It depends on how fast workers and firms adjust their expectations
about future inflation. This depends on inflation itself. The U.S. has
seen three types of inflation of the last several decades:
• Low inflation: slow adjustment, since workers and firms seem to
ignore inflation
• Moderate but stable inflation: quick adjustment; stable but
noticeable inflation is easily incorporated into expectations
• High and unstable inflation: quick adjustment again, but for a
different reason: forming rational expectations about inflation
becomes very important, so workers and firms pay a lot of
attention to forecasting inflation
Rational expectations: Expectations formed by using all available
information about an economic variable.
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The Effect of Rational Expectations on Monetary Policy
If workers and firms have
adaptive expectations,
expecting inflation to be the
same as it was last period, then
expansionary monetary policy
can increase employment.
But if they have rational
expectations, workers and
firms will anticipate the Fed’s
policies, and adjust their
expectations about inflation
accordingly.
• Then the policy would have
no effect on employment:
the short-run Phillips curve
would be vertical also.
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Figure 17.8
Rational expectations
and the Phillips curve
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Is the Short-Run Phillips Curve Really Vertical?
This idea of rational expectations and a vertical short-run Phillips
curve was proposed by Nobel Laureates Robert Lucas and Thomas
Sargent.
Their critics argued that the 1950s and 1960s showed an obvious
short-run trade-off between unemployment and inflation.
Lucas and Sargent: This happened because the Fed was secretive,
not announcing changes in policy. If the Fed announces its policies,
people will correctly anticipate inflation.
Critics: Workers and firms still cannot correctly anticipate inflation;
their expectations are not rational.
Besides, wages and prices don’t adjust fast enough anyway; so even
if people anticipated the inflation, they couldn’t do enough about it to
make the short-run Phillips curve vertical.
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Real Business Cycle Models
The conclusion from Lucas and Sargent was the Fed could affect
output and employment; but only through unexpected changes to the
money supply.
• During the 1980s, a different mechanism for explaining changes in
real GDP: technology shocks—increases or decreases in
productive ability—might push real GDP above or below its
(previous) potential level.
Since this was based on real (not monetary) factors, models based
on this became known as real business cycle models.
Real business cycle models: Models that focus on real rather than
monetary explanations of the fluctuations in real GDP.
• These models assume rational expectations and quickly-adjusting
prices, as did Lucas and Sargent; collectively, these two
approaches are known as the new classical macroeconomics.
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Federal Reserve Policy from the 1970s to the Present
17.4 LEARNING OBJECTIVE
Use a Phillips curve graph to show how the Federal Reserve can permanently
lower the inflation rate.
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Oil Price Shocks in the 1970s
Figure 17.9
A supply shock
shifts the SRAS
curve and the
short-run Phillips
curve
The graphs show the U.S. economy in 1973: moderate but
anticipated inflation, hence unemployment at its natural rate.
• In 1974, OPEC caused oil prices to rise dramatically. This was a
supply shock, decreasing short-run aggregate supply.
• Unemployment rose but so did people’s expectations of inflation—
a higher short-run Phillips curve.
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The Fed’s Response
Figure 17.9
A supply shock
shifts the SRAS
curve and the
short-run Phillips
curve
What could the Fed do? It wanted to fight both inflation and
unemployment, but the short-run Phillips curve makes clear that
improving one worsens the other.
• The Fed chose expansionary monetary policy: reducing
unemployment, at the cost of even more inflation.
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High Inflation: Must It Continue?
The newly high
inflation was
incorporated into
people’s expectations
and became selfreinforcing.
The Fed’s new
chairman, Paul Volcker,
wanted inflation lower,
believing high inflation
was hurting the
economy.
Figure 17.10
The Fed tames inflation,
1979-1989
• So Volcker announced and enacted a contractionary monetary
policy. If people believed the announcement, they would adjust
down to a lower Phillips curve.
• But for several years, the Phillips curve appeared not to move.
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Did Rational Expectations Fail?
Does this prove
people were not forming
their expectations about
inflation rationally?
Not necessarily. The
Fed had a credibility
problem: it had
previously announced
contractionary policies
but allowed inflation to
occur anyway.
Figure 17.10
The Fed tames inflation,
1979-1989
Eventually, several years of tight money convinced people that
inflation would be lower.
• Prices fell, and so did expectations about inflation: a new, lower
short-run Phillips curve. This was disinflation: a significant
reduction in the inflation rate.
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Fed Chairmen and Inflation
Federal Reserve
Chairman
Average Annual Inflation
Rate During Term
Term
William McChesney Martin
April 1951–January 1970
2.2%
Arthur Burns
February 1970–January 1978
6.5
G. William Miller
March 1978–August 1979
9.1
Paul Volcker
August 1979–August 1987
6.2
Alan Greenspan
August 1987–January 2006
3.1
Ben Bernanke
January 2006–January 2014
2.3
Table 17.3
The record of Fed
chairmen and inflation
Fed policies in the 1970s resulted in high inflation.
Volcker, Greenspan, and Bernanke were all determined to keep
inflation low.
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Alan Greenspan at the Helm
When he left the Fed, Alan Greenspan’s term appeared very
successful:
• Low inflation
• Only two recessions—both short and mild (1990-1991, 2001)
• Increased Fed credibility (following through on announced actions)
• Increased Fed transparency (since 1994, federal funds rate target
has been made public)
Greenspan also oversaw the deemphasizing of the money supply as
a Fed monetary policy target, and the increased interest rates—the
federal funds rate, in particular.
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Alan Greenspan at the Helm: LTCM
With hindsight, two Fed actions during Greenspan’s tenure appear to
have worsened the 2007-2009 recession:
1. Saving hedge fund Long-Term Capital Management (LTCM)
LTCM suffered heavy investment losses in 1998. Owing money to
other firms, it was going to have to sell off its investments quickly to
repay debts.
• Rather than causing the prices to fall in this manner, the Fed
intervened and helped LTCM make arrangements with its creditors
to unwind its investments slowly.
• This action set the precedent for helping over-leveraged financial
firms, and may have encouraged financial firms to take too many
risks, exacerbating the financial crisis.
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Alan Greenspan at the Helm: Federal Funds Rate
With hindsight, two Fed actions during Greenspan’s tenure appear to
have worsened the 2007-2009 recession:
2. Keeping the federal funds rate at 1% from June 2003 to June
2004
• In 2001, the economy experienced a recession.
• By 2003, the recession was long over, but the Fed kept interest
rates low anyway.
• This encouraged borrowing and may have exacerbated the
housing bubble.
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Making
the
Connection
The Debate over Quantitative Easing
Beginning in November 2008, Fed
Chairman Ben Bernanke instituted a policy
of quantitative easing (QE):
• Fed purchased long-term Treasuries
and mortgage-backed securities to
reduce long-term interest rates.
Critics of QE have said it could result in:
• Speculative asset price bubbles
• Excessive financial risk-taking
• Unfavorable changes in savings
behavior
• A credibility problem for the Fed, due to
its deviation from rules-based monetary
policy.
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Central Bank Independence and Inflation
In 1993, economists
Alberto Alesina and Larry
Summers demonstrated
an important link between
the inflation rate in highincome countries and the
degree of independence
their central banks had
from the rest of the
government.
They concluded that, in
order to continue to fight
inflation, the Fed would
need to maintain its
independence.
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Figure 17.11 The more independent
the central bank, the
lower the inflation rate
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Has the Fed Lost Its Independence?
The financial crisis of 2007-2009, and the Fed’s extraordinary actions
resulting from it, have prompted much political attention for the Fed.
• While typically the Fed has taken actions independently of the
Treasury Department, during the crisis the two worked closely
together.
• Also, by keeping interest rates low, the Fed has made it easier for
the federal government to run large deficits.
Ultimately, time will tell whether this apparent decrease in
independence will have negative consequences for the U.S.
economy.
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Common Misconceptions to Avoid
Inflation and “expectations about inflation” are different but related
concepts.
• Changes in current inflation cause movements along the short-run
Phillips curve, changes in expectations about inflation cause shifts
of the short-run Phillips curve.
Disinflation and deflation are not the same; disinflation refers to
significantly reducing the inflation rate, whereas deflation is a
negative inflation rate.
Remember that as long as the short-run Phillips curve is not vertical,
the Fed can improve inflation or unemployment but not both
simultaneously.
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