Download Phillips curve

The Short-Run
Tradeoff between
Inflation and
Unemployment
22
Copyright © 2004 South-Western
Unemployment and Inflation
• The natural rate of unemployment depends on
various features of the labor market.
• Examples include minimum-wage laws, 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 quantity of money, controlled by the Fed.
Copyright © 2004 South-Western
Unemployment and Inflation
• Society faces a short-run tradeoff between
unemployment and inflation.
• If policymakers expand aggregate demand, they
can lower unemployment, but only at the cost
of higher inflation.
• If they contract aggregate demand, they can
lower inflation, but at the cost of temporarily
higher unemployment.
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THE PHILLIPS CURVE
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.
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Figure 1 The Phillips Curve
Inflation
Rate
(percent
per year)
B
6
A
2
Phillips curve
0
4
7
Unemployment
Rate (percent)
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Aggregate Demand, Aggregate Supply, and
the Phillips Curve
• The Phillips curve shows the short-run
combinations of unemployment and inflation
that arise as shifts in the aggregate demand
curve move the economy along the short-run
aggregate supply curve.
• It is drawn for one level of AS. A shift of AS
will generate a new level of the Phillips curve.
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Figure 2 How the Phillips Curve is Related to
Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
102
Inflation
Rate
(percent
per year)
Short-run
aggregate
supply
6
B
106
B
A
High
aggregate demand
Low aggregate
demand
0
(b) The Phillips Curve
7,500 8,000
(unemployment (unemployment
is 7%)
is 4%)
Quantity
of Output
A
2
Phillips curve
0
4
(output is
8,000)
Unemployment
7
(output is Rate (percent)
7,500)
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The Long-Run Phillips Curve
• Long-run Phillips curve is vertical
• It represents the natural rate of unemployment
• It may be shifted by changes in the labor
market, such as increases in unemployment
compensation, changes in minimum wage laws.
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Figure 3 The Long-Run Phillips Curve
Inflation
Rate
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
High
inflation
Low
inflation
0
Long-run
Phillips curve
B
A
Natural rate of
unemployment
2. . . . but unemployment
remains at its natural rate
in the long run.
Unemployment
Rate
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Figure 4 How the Phillips Curve is Related to
Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
P2
2. . . . raises
the price
P
level . . .
Long-run aggregate
supply
1. An increase in
the money supply
increases aggregate
B
demand . . .
(b) The Phillips Curve
Inflation
Rate
Long-run Phillips
curve
3. . . . and
increases the
inflation rate . . .
B
A
A
AD2
Aggregate
demand, AD
0
Natural rate
of output
Quantity
of Output
0
Natural rate of
unemployment
Unemployment
Rate
4. . . . but leaves output and unemployment
at their natural rates.
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Expectations and the Short-Run Phillips
Curve
Unemployment Rate =

Expected
Natural rate of unemployment - a Actual

inflation inflation

• This equation relates the unemployment rate to
the natural rate of unemployment, actual
inflation, and expected inflation.
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Figure 5 How Expected Inflation Shifts the ShortRun Phillips Curve
Inflation
Rate
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Long-run
Phillips curve
C
B
Short-run Phillips curve
with high expected
inflation
A
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
0
Short-run Phillips curve
with low expected
inflation
Natural rate of
unemployment
Unemployment
Rate
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The Natural Experiment for the Natural-Rate
Hypothesis
• The view that unemployment eventually returns
to its natural rate, regardless of the rate of
inflation, is called the natural-rate hypothesis.
• Historical observations support the natural-rate
hypothesis.
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Figure 6 The Phillips Curve in the 1960s
Inflation Rate
(percent per year)
10
8
6
1968
4
1967
2
0
1966
1962
1965
1964
1963
1
2
3
4
5
6
1961
7
8
9
10 Unemployment
Rate (percent)
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Figure 7 The Shift of the Phillips Curve
Inflation Rate
(percent per year)
10
8
6
1973
1971
1969
1968
4
1970
1972
1967
2
0
1966
1962
1965
1964
1963
1
2
3
4
5
6
1961
7
8
9
10 Unemployment
Rate (percent)
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SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• The short-run Phillips curve also shifts because
of shocks to aggregate supply.
• Major adverse changes in aggregate supply can
worsen the short-run tradeoff between
unemployment and inflation.
• An adverse supply shock gives policymakers a less
favorable tradeoff between inflation and
unemployment.
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Figure 8 An Adverse Shock to Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
AS2
P2
3. . . . and
raises
the price
level . . .
B
A
P
Aggregate
supply, AS
(b) The Phillips Curve
Inflation
Rate
1. An adverse
shift in aggregate
supply . . .
4. . . . giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
A
PC2
Aggregate
demand
0
Y2
Y
2. . . . lowers output . . .
Quantity
of Output
Phillips curve, P C
0
Unemployment
Rate
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Figure 9 The Supply Shocks of the 1970s
Inflation Rate
(percent per year)
10
1980
1974
8
1981
1975
1979
1978
6
1977
1973
4
1976
1972
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, the Fed has to pursue
contractionary monetary policy.
• When the Fed slows the rate of money growth,
it contracts aggregate demand.
• This reduces the quantity of goods and services
that firms produce.
• This leads to a rise in unemployment.
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Figure 10 Disinflationary Monetary Policy in the
Short Run and the Long Run
Inflation
Rate
Long-run
Phillips curve
1. Contractionary policy moves
the economy down along the
short-run Phillips curve . . .
A
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
2. . . . but in the long run, expected Rate
inflation falls, and the short-run
Phillips curve shifts to the left.
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THE COST OF REDUCING
INFLATION
• To reduce inflation, an economy must endure a
period of high unemployment and low output.
• When the Fed combats inflation, the economy
moves down the short-run Phillips curve.
• The economy experiences lower inflation but at the
cost of higher unemployment.
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Rational Expectations and the Possibility of
Costless Disinflation
• Expected inflation 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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The Volcker Disinflation
• When Paul Volcker became Fed chairman in
the 1980, inflation was widely viewed as one of
the nation’s foremost problems.
• Volcker succeeded in reducing inflation (from
10 percent to 4 percent), but at the cost of high
unemployment (about 10 percent in 1983).
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Figure 11 The Volcker Disinflation
Inflation Rate
(percent per year)
10
1980 1981
A
1979
8
1982
6
1984
4
B
1983
1987
1985
C
1986
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
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Figure 12 The Greenspan Era
Inflation Rate
(percent per year)
10
8
6
1990
1991
1989
1984
1988
1985
1987
2001
1995
1992
2000
1986
1997
1994
1993
1999
2002
1998 1996
4
2
0
1
2
3
4
5
6
7
8
9
10 Unemployment
Rate (percent)
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Positive changes in Aggregate
Supply
• The best way to achieve low inflation and low
unemployment is to experience an increase in
the aggregate supply.
• Increase in AS moves Phillips curve to a lower
level, giving the government a better trade-off
between inflation and unemployment.
• Example: technological change in the 1990s.
• Problem: AS cannot be freely changed by
government policy.
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