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Chapter 21 The Short-Run Tradeoff between
Inflation and Unemployment
• The Phillips Curve
• Shifts in the Phillips Curve: the role of
expectations
• Shifts in the Phillips Curve: the role of
Supply Shocks
• The Cost of Reducing Inflation
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• Two closely watched indicators of economic performance
are inflation and unemployment.
• How are these two measures of economic performance
related to each other?
• We saw that the natural rate of unemployment depends on
various features of the labour market, such as minimum
wage laws, the generosity of Employment Insurance, the
market power of unions, the role of efficiency wages, and
the effectiveness of job search.
• The inflation rate depends primarily on growth in the money
supply, which a nation’s central bank controls.
• In the long run, therefore, inflation and unemployment are
largely unrelated problems.
• In the short run, the opposite is true. The society faces a
short-run trade off between inflation and unemployment.
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The Phillips Curve
• Macroeconomics focuses on three primary areas of our
economy — output, prices, and unemployment.
– If policy-makers expand aggregate demand, they can
lower unemployment, in the short-run, but only at the
cost of higher inflation.
– If they contract aggregate demand, they can lower
inflation, but at the cost of higher unemployment.
• The Phillips curve illustrates the tradeoff between inflation
and unemployment — a short-run negative relationship.
• See Figure 21-1.
• The greater the aggregate demand for goods and services,
the greater is the economy’s output and the higher the
overall price level.
• Imagine that the price level, such as CPI, equals 100 in 3the
year 2000. Figure 21-2 shows two possible outcomes,
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CPI=102 or CPI=106, that might occur in year 2001.
If the AD for goods and services is relatively low, the
economy experiences outcome A. The economy produces
output of 7500 and the price level is 102. By contrast, if AD
is relatively high, the economy experiences outcome B. The
economy produces output of 8000 and the price level is 106.
Thus, higher AD moves the economy to an equilibrium with
higher output and a higher price level.
Because firms need more workers when they produce a
greater outcome of goods and services, unemployment is
lower when output is higher. So, a higher level of output
results in a lower level of unemployment.
Monetary and fiscal policy can shift the aggregate demand
curve, thus moving the economy along the Phillips curve.
Summary: The Phillips Curve relates inflation and
unemployment in the short-run as shifts occur in the 4
aggregate demand and aggregate supply.
• Policy-makers face a tradeoff between inflation and
unemployment, and the Phillips Curve illustrates that
tradeoff.
– Okun’s Law: the number of percentage points the
unemployment rate increases when GDP falls by 1
percentage point.
– So, Okun’s law tells us that greater output means a lower
rate of unemployment but at a higher overall price level.
• See Figure 21-6, the Phillips curve in the 1950s and 1960s.
• See Figure 21-7, the breakdown of the Phillips Curve
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• It has been suggested that the Phillips curve offers policymakers a “menu of possible economic outcomes.”
• Historical events have shown that the Phillips Curve can
shift due to the following factors:
– Expectations
– Supply Shocks
• The concept of a stable Phillips Curve broke down in the
1970s and 1980s. During the 70s and 80s the economy
experienced high inflation and high unemployment
simultaneously.
• Economists determined that monetary policy was effective
in the short-run in picking a combination of inflation and
unemployment, but not in the long-run
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Shifts in the Phillips Curve: The role of expectations
• In the long-run, expected inflation adjusts to changes in
actual inflation, and the short-run Phillips Curve shifts.
– Once people anticipate inflation, the only way to get
unemployment below the natural rate is for actual
inflation to be above the anticipated rate.
– As a result, the long-run Phillips Curve is vertical at the
natural rate of unemployment.
• See Figure 21-3
• In the long-run, with a vertical Phillips Curve at the natural
rate of unemployment, the actual rate of inflation and
unemployment will depend upon aggregate supply factors
and the fiscal and monetary policies pursued by the
government. See Figure 21-4.
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How expected inflation shifts the short-run Phillips Curve
• See Figure 21-5
• The higher the expected rate of inflation, the higher the
short-run tradeoff between inflation and unemployment.
• At Point A, expected inflation are actual inflation are both
low, and unemployment is at its natural rate. If the B of C
pursues an expansionary monetary policy, the economy
moves from point A to point B in the short run. Why?
• At Point B, expected inflation is still low, but actual
inflation is high. Unemployment is below its natural rate.
• In the long run, expected inflation rises and the economy
moves to Point C. At this point, expected inflation and
actual inflation are both high and unemployment is back to
its natural rate. The view that unemployment eventually
returns to its natural rate, regardless of the rate of inflation
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is called the natural-rate hypothesis.
Shifts in the Phillips Curve: the role of Supply Shocks
• The short-run Phillips Curve also shifts because of shocks to
aggregate supply.
• An adverse supply shock, such as an increase in world oil
prices, gives policy-makers a less favorable tradeoff
between inflation and unemployment.
• See Figure 21-8
• When the AS shifts to left, the equilibrium price level rises
and quantity of output falls. The adverse shift in AS moves
the economy from a point with lower unemployment and
lower inflation to a point with higher unemployment and
higher inflation.
• Major changes in aggregate supply can “worsen” the shortrun tradeoff between unemployment and inflation.
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• Example: 1974 OPEC actions. OPEC in the 1970s (1) cut
output and (2) raised prices. The tradeoff in this situation
resulted in two choices:
– Fight the unemployment battle with monetary expansion
(and accelerate inflation).
– Stand firm against inflation (but endure even higher
unemployment).
• See Figure 21-9
• Increases in the world price of oil in the early 1970s and
again in 1979 caused large jumps in the rate of inflation and
caused the short-run Phillips curve to shift to the right.
• In between these two oil price shocks, tight monetary policy
and wage and price controls caused Canada to slide down a
temporarily stable short-run curve.
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The Cost of Reducing Inflation
• To reduce inflation, the B of C has to pursue contractionary
monetary policy (e.g. raising interest rates, etc.).
• When the B of C slows the rate of money growth:
– It contracts the aggregate demand, which reduces the
quantity of goods and services that firms produce, which
leads to a fall in employment.
• Given the actions of the B of C in combating inflation, the
economy moves along (downward) the short-run Phillips
Curve, resulting in lower inflation but higher
unemployment. If an economy is to reduce inflation it must
endure a period of high unemployment and low output.
• See Figure 21-10. The economy moves from point A to B.
Over time, expected inflation falls and the short-run Phillips
curve shifts downward. When the economy reaches point
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C,unemployment is back to its natural rate.
• The sacrifice ratio is the number of percentage points of
one year’s output that is lost in the process of reducing
inflation by one percentage point.
• A typical estimate of the sacrifice ratio is between 2 and 5
percentage points.
• We can also express the sacrifice ratio in terms of
unemployment. Reducing inflation by 1 percentage point
requires a sacrifice of between 1 and 2.5 percentage points
of unemployment.
• In some years (e.g. 1979) the sacrifice ratio was very large
indicating a high level of unemployment was to be
experienced in order to reduce inflation to acceptable levels.
• To reduce inflation from about 10% in 1979 to 4% would
require an estimated sacrifice of 30 percent of one year’s
output and 15 percentage points of unemployment. 12
Rational Expectations
• The theory of rational expectations suggests that people
optimally use all the information they have, including
information about government policies, when forecasting
the future.
• The theory of rational expectations suggested that the time
and therefore the sacrifice-ratio, could be shorter and lower
than estimated.
• Expected inflation is an important variable that explains
why there is a tradeoff between inflation and unemployment
in the short-run, but not in the long-run.
• How quickly the short-run tradeoff disappears depends on
how quickly expectations adjust.
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Disinflation in the 1980s
• When the B o C at the beginning of the 1980s faced the
prospect of reducing inflation from its peak of about 11%,
the economics profession offered two conflicting
predictions.
• One group of economists offered estimates of the sacrifice
ratio and concluded that reducing inflation would have great
cost in terms of lost output and high unemployment.
• Another group offered the theory of rational expectations
and concluded that reducing inflation could be much less
costly and perhaps could even have no cost at all.
• See Figure 21-11. Disinflation in the 1980s.
• Inflation did decrease from almost 11% in 1980/1981 to
about 2.5% in 1985/1986. At the same time, the production
of goods and services, real GDP was well below its trend
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level.
• The disinflation of the early 1980s produced the deepest
recession in Canada since the Great Depression of the
1930s.
• Does this experience refute the possibility of costless
disinflation as suggested by the rational-expectations
theorists?
• Some economists have argued that the answer to this
question is a resounding yes. The estimate of the sacrifice
ration for the period of 1981 to 1988 is 2.3. This is at the
upper end of estimates of the sacrifice ratio suggested by
those economists who argued that reducing inflation could
come only at a great cost in terms of lost output and high
unemployment. For those economists, then, the claims of
rational-expectations theorists that less costly disinflation
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was possible seemed to carry little weight.
The zero-inflation target
• In 1988, then Governor of the B of C, John Crow, made a
speech known as the Hanson lecture. In it he asserted that
the sole goal of the B of C would thereafter be to achieve
and maintain a stable price level and zero inflation.
• The Bank’s target was reached by 1992 by which time the
unemployment rate had increased to over 11 percent.
• See Figure 21-12. It shows that the unemployment rate
increased from 7.5% in 1989 to 11.4% in 1993, while
inflation rate fell from 4.%% to 1.5%.
• From 1993 to 1999, the inflation rate averaged just over 1%,
so that the target was successfully maintained.
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