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Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 16: The Short-run Tradeoff Between Inflation and Unemployment Long-run Unemployment • The natural rate of unemployment (the longrun unemployment rate) depends on the characteristics of the labor market. – Effectiveness of job search. – Skill gaps between labor demand and labor supply. – Efficiency wages. – Union power. – Minimum wage laws. Econ 202 Dr. Ugur Aker 2 Long-run Inflation • Inflation in the long-run is strictly a monetary phenomenon. • Classical “Quantity Theory” works in the long run. • In the long-run, inflation and unemployment are unrelated. – A country can have any inflation rate at the natural rate of unemployment. Econ 202 Dr. Ugur Aker 3 Short Run • In the short run, aggregate supply is upward sloping. – Long run aggregate supply is a vertical line. • Any shift in the aggregate demand curve will affect unemployment and inflation in opposite directions initially. • After the adjustment of prices, unemployment will reach the natural rate. Econ 202 Dr. Ugur Aker 4 Short-run LRAS SRAS P3 P2 AD3 P* AD2 AD1 Y* Y2 Y3 Econ 202 Dr. Ugur Aker An increase in C or I or G or NX will shift the AD to the right. In the short run, GDP will increase but so will the price level. The economy will experience a drop in the unemployment rate but a positive inflation rate. If the AD had shifted to the left, inflation would have fallen, but unemployment would have risen. 5 Keynesian Theory • The negative connection between inflation and unemployment is the logical conclusion of Keynesian theory. – Prices and wages are constant in the short run. – An increase in money supply, increases the GDP. – But an increase in GDP (a fall in unemployment) will usher in an increase in the price level. Econ 202 Dr. Ugur Aker 6 Phillips Curve • In 1958, A. W. Phillips published an article showing the relationship between nominal wages and unemployment rates in Britain for a century. • When one took the average of the observations, i.e., when one tried to fit a single line to summarize the observations, the line was downward sloping. • This relationship is termed Phillips curve since. Econ 202 Dr. Ugur Aker 7 Phillips Curve for the US • Samuelson and Solow showed the same relationship for the US (1960). • They used inflation rate instead of the nominal wage increase. • Once this relationship is established, it made sense in the sixties to talk about the choice a government had. – Low inflation and high unemployment – High inflation and low unemployment Econ 202 Dr. Ugur Aker 8 Unemployment and Inflation Econ 202 Dr. Ugur Aker 9 Unemployment and Inflation Econ 202 Dr. Ugur Aker 10 Objections to Phillips Curve • By the end of the sixties, Friedman and Phelps questioned the wisdom of viewing unemployment and inflation trade-off in the long-run. • They emphasized the classical dichotomy. – Real variables cannot be influenced by monetary factors. – Monetary policy will affect nominal variables. • In the long-run, Phillips curve is vertical at the natural unemployment rate. Econ 202 Dr. Ugur Aker 11 Long Run P Infl. rate LRAS SRAS Long run Phillips curve SRAS AD P* AD Y* Y Econ 202 Dr. Ugur Aker U* Unemp. rate 12 How To Reconcile Phillips Curves • The data showed downward sloping Phillips curve. • The theory claimed vertical Phillips curve. • In the short-run Phillips curves are downward sloping. • However, there is not one but many Phillips curves, each one indicating a different expected inflation rate. Econ 202 Dr. Ugur Aker 13 Short Run and Long Run P Infl. rate LRAS SRAS SRAS 5% 3% AD P* AD Y* SRPhC Long run Phillips curve Y U* Expected inflation on the white SRPhC is 3%. When expected inflation rises to 5%, SRPhC shifts to the blue one. Econ 202 Dr. Ugur Aker Unemp. rate 14 How the Fed Can Fuel Inflation LRPhC 7% 4 5 Pe=7% 2 4% 3 Pe=4% 11 2% Pe=2% 4% 6% Econ 202 Dr. Ugur Aker 15 Inflation-Unemployment in the 1960s Econ 202 Dr. Ugur Aker 16 Unemployment-Inflation 1961-73 Econ 202 Dr. Ugur Aker 17 Cost of Production Increase • A shock to the economy that raises the cost of production in general, will shift the SRAS to the left. • At the same inflation level unemployment rises, shifting SRPhC to the right. • Oil price shocks of 1973 and 1980 had this influence on the economy. • Oil price collapse of 1985 had the opposite result. Econ 202 Dr. Ugur Aker 18 Oil Price Shock LRAS SRAS P P* LRPhC SRAS SRAS 6% 5% 3% Pe=6% Pe=5% Pe=3% AD U* U Y Y* Econ 202 Dr. Ugur Aker 19 Unemployment-Inflation 1972-81 Econ 202 Dr. Ugur Aker 20 Oil Price Collapse LRPhC LRAS SRAS SRAS P P SRAS 4% SRPhC 3% SRPhC SRPhC AD Y* Y U U* Econ 202 Dr. Ugur Aker 21 Unemployment-Inflation 1979-87 Econ 202 Dr. Ugur Aker 22 Unemployment-Inflation 1984-95 Econ 202 Dr. Ugur Aker 23 Cost of Reducing Inflation • Suppose the economy is in long-run equilibrium with 10% inflation. • Draw it. • Suppose the Fed wants to reduce the inflation. • What should the Fed do? • What would be the cost to the society? Econ 202 Dr. Ugur Aker 24 Cost of Reducing Inflation LRAS LRPhC Pe=10% SRAS 10% P AD AD Y* U* Econ 202 Dr. Ugur Aker 25 Unemployment-Inflation 1979-87 Econ 202 Dr. Ugur Aker 26 Cost of Reducing Inflation • The sacrifice the society has to go through is the high unemployment rate it has to endure until inflationary expectations are lowered to acceptable levels. • The Volcker years of the Fed were severe unemployment period but inflation was lowered from two digit levels down to 4%. • The cost was supposed to be 5% drop of GDP per one percent of inflation drop. • Perhaps because of rational expectations the cost was lower. Econ 202 Dr. Ugur Aker 27