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Chapter 13
Unemployment and
Inflation
Copyright © 2012 Pearson Education Inc.
Unemployment and
Inflation
The Phillips curve is a negative
empirical relationship between
unemployment and inflation.
 In 1970-2009 there seemed to be
no reliable relationship between
unemployment and inflation.

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Unemployment and
Inflation
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The Expectations
Augmented Phillips Curve
A
negative relationship should
exist between unanticipated
inflation and cyclical
unemployment.
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The Phillips Curve
(continued)

If increase in M is
anticipated, and if
there is no
misperception, the
economy remains at Y
, unemployment
remains at u, and
cyclical unemployment
is zero.
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The Phillips Curve
(continued)

If increase in M is unanticipated,
unanticipated inflation is created,
Y is above Y , and u is below u .
π  π  h(u  u )
e

h measures the strength of the
relationship between
unanticipated inflation and cyclical
unemployment.
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The Phillips Curve
(continued)
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The Phillips Curve
(continued)

The expectation-augmented
Phillips curve states that if π
exceeds πe then u is less than u .
π  π  h(u  u )
e
h is related to the slope of the SRAS
curve.
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Shifting of the Philips Curve

The Phillips curve depends on the
expected rate of inflation and the
natural rate of unemployment. If
either factor changes the Phillips
curve will shift.


π  π  hu  hu
e
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Changes in the Expected
Rate of Inflation

If households anticipate a change
in the price level they respond by
their expectations of the price
level (the rate of inflation) onefor-one.
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Changes in the Expected
Rate of Inflation

The Phillips
curve shifts up
by the amount
of the increase
in the expected
rate of inflation.
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Changes in the Natural Rate
of Unemployment

An increase in
the natural
unemployment
rate causes the
Phillips curve to
shift up and to
the right.
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Supply Shocks and the
Phillips Curve

An adverse supply shock causes a
burst of inflation and raises the
natural rate of unemployment:
by increasing the degree of mismatch
between workers and jobs (classical
economists);
 by reducing MPN and labour
demanded at full employment
(Keynesian economists).

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Supply Shocks and the
Phillips Curve
An adverse supply shock should
shift the Phillips curve up and to
the right.
 The Phillips curve should be
particular unstable during periods
of supply shocks.

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The Shifting Phillips Curve
in Practice

The Friedman-Phelps analysis
shows that a negative relationship
between the levels of inflation and
unemployment holds as long as
expected inflation and the natural
unemployment rate are
approximately constant.
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The Shifting Phillips Curve
in Practice (continued)
During 1970-2009 there was a
number of productivity shocks as
well as changes in government
and macroeconomic policies.
 A negative relationship between
unanticipated inflation and cyclical
unemployment does appear in the
data.

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The Shifting Phillips Curve
in Practice (continued)
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Macroeconomic Policy and
the Phillips Curve

Keynesians believe that in a
recession expansionary AD policy
can increase inflation back to the
anticipated levels that were used
as a basis for nominal wage
contracts and pricing.
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The Lucas Critique

Because new policies change the
economic “rules” and, thus, affect
economic behaviour, no one can
safely assume that historical
relationships between variables
will hold when policies change.
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The Long-Run Phillips Curve
Economists agree that in the long
run economy will adjust to the
general equilibrium where π=πe
and u= u .
 The long-run Phillips curve is
vertical line at u= u . It is related
to the long-run neutrality of
money.

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The Cost of Unemployment
The output is lost because fewer
people are productively employed.
 Unemployed workers and their
families face psychological cost.
 The offsetting factors are
acquiring new skills and more
leisure time.

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The Long-Term Behaviour
of the Unemployment Rate

The long-term unemployment rate
may be influenced by:
changes in the composition of the
labour force by age and sex;
 structural changes in the economy
brought about by technological
change

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The Long-Term Behaviour
of the Unemployment Rate
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Hysteresis in
Unemployment
Hysteresis in unemployment
means that the natural
unemployment rate changes in
response to the actual
unemployment rate.
 If workers are idle for long periods
of time their skills deteriorate and
the mismatch increases.

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Hysteresis in
Unemployment (continued)
Some regulations on firms may
cause them to be cautious about
hiring workers because the
regulations make it difficult to fire
them.
 Insider-outsider theory suggests
that unionized labour increases
wages for insiders and leaves
outsiders unemployed.

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How to Reduce the Natural
Rate of Unemployment
Increase government support for
job training and reallocation.
 Increase labour market flexibility.
 Reform the Employment Insurance
program.
 Use aggressive policy to keep
actual unemployment rate low.

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Perfectly Anticipated
Inflation
Because nominal wages are rising
together with prices, the
purchasing power is not hurt by
the perfectly anticipated inflation.
 Perfectly anticipated inflation
would not hurt the value of
savings accounts.

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The Cost of Perfectly
Anticipated Inflation
Shoe leather costs of inflation is
time and effort incurred by people
and firms who are trying to
minimize their holdings of cash.
 Menu costs of inflation.
 Welfare costs of inflation-induced
tax distortions.

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The Cost of Unanticipated
Inflation

Creditors and those with incomes
set in nominal terms are hurt,
whereas debtors and those who
make fixed nominal payments are
helped by unanticipated inflation.
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The Cost of Unanticipated
Inflation (continued)
People are made worse off by
increasing risk of gaining or losing
wealth as a result of unanticipated
inflation.
 People must spend time and effort
learning about different prices.

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The Cost of Hyperinflation

Hyperinflation occurs when the
inflation rate is extremely high for
a sustained period of time.
The shoe leather costs are enormous.
 The government’s ability to collect
taxes is undermined.
 The market efficiency is disrupted.

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Fighting Inflation: The Role
of Inflationary Expectations
The only factor that can create
sustained rises in aggregate
demand and ongoing inflation is a
high rate of money growth.
 Governments may print money to
finance their spending or use
monetary policy to fight recession.

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Fighting Inflation
(continued)



The process of disinflation – the
reduction of money growth – can lead
to a recession.
If inflation falls below the expected
rate, unemployment will rise above the
natural rate.
A recession can be avoided if the
expected inflation rate can be made to
fall.
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Rapid versus Gradual
Disinflation
A cold turkey strategy is a rapid
and decisive reduction in the
growth rate of the money supply.
 It may lead to a significant
increase in cyclical unemployment.

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Rapid versus Gradual
Disinflation (continued)
Inflation expectations may not
lower if the government is
expected to abandon the policy
under political pressure.
 A policy of gradualism is a policy
of reducing the rate of money
growth gradually over a period of
time.

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Rapid versus Gradual
Disinflation (continued)

This policy will raise
unemployment by less than the
cold-turkey strategy, but the
period of higher unemployment
will be longer.
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Wage and Price Controls



Wage and price controls (income
policies) are legal limits on the ability of
firms to raise wages or prices.
Price controls are likely to create
shortages.
Wage-price controls are intended to
affect the public’s expectations of
inflation.
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Credibility and Reputation
The expected inflation adjusts
quickly if government’s announced
disinflationary policy is credible.
 Policymakers increase their
credibility by developing a
reputation for carrying through on
promises.

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Credibility and Reputation
(continued)

A strong and independent central
bank is more likely to be deemed
a credible policymaker by the
public.
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