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The Short-Run
Trade-Off between
Inflation and
Unemployment
Copyright © 2010 Cengage Learning
10
Unemployment and Inflation
• What are the determinants of the natural rate of
unemployment?
• The natural rate of unemployment is determined by
minimum wage laws, the market power of unions,
the role of efficiency wages, and the effectiveness
of job search.
• What is the determinant of the inflation rate?
• The inflation rate depends primarily on growth in
the quantity of money, controlled by the central
bank.
Copyright © 2010 Cengage Learning
Unemployment and Inflation
• Society faces a short-run trade-off 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.
This lecture considers the following issues:
• Why policymakers face the short-run trade-off between
unemployment and inflation? Why it disappears in the long run?
• How can supply shocks shift the trade-off?
• What is the short-run cost of reducing the rate of inflation?
• How the policy-makers’ credibility affects the cost of reducing
inflation?
Copyright © 2010 Cengage Learning
Figure 1 The Phillips Curve
Inflation
Rate
(percent
per year)
B
6
A
2
Phillips curve
0
4
7
Unemployment
Rate (percent)
Copyright©2010 South-Western
Aggregate Demand, Aggregate Supply, and
the Phillips Curve
• The Phillips curve illustrates the short-run relationship
between inflation and unemployment.
• 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.
• The greater the aggregate demand for goods and
services, the greater is the economy’s output, and the
higher is the overall price level.
• A higher level of output results in a lower level of
unemployment.
Copyright © 2010 Cengage Learning
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)
Copyright©2010 South-Western
The Long-Run Phillips Curve
• The Phillips curve seems to offer policy makers
a menu of possible inflation and unemployment
outcomes.
• In the 1960s, Friedman and Phelps concluded
that inflation and unemployment are unrelated
in the long run.
• As a result, the long-run Phillips curve is vertical at
the natural rate of unemployment.
• Monetary policy could be effective in the short run
but not in the long run.
Copyright © 2010 Cengage Learning
Figure 3 The Long-Run Phillips Curve
Inflation
Rate
1. When the
High
central bank
inflation
increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
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
Copyright©2010 South-Western
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.
Copyright©2010 South-Western
Expectations and the Short-Run Phillips
Curve
• Expected inflation measures how much people expect the
overall price level to change.
• In the long run, expected inflation adjusts to changes in
actual inflation.
Expected 
 Actual
Unemployment
Natural Rate of


― a
=
Inflation 
Rate
Unemployment
 Inflation
• The central bank’s ability to create unexpected inflation
exists only in the short run.
• Once people anticipate inflation, the only way to get
unemployment below the natural rate is for actual inflation
to be above the anticipated rate.
Copyright © 2010 Cengage Learning
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
Copyright©2010 South-Western
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.
• The stable Phillips curve relationship between inflation
and unemployment broke down in the in the early
’70s.
• During the ’70s and ’80s, many economies
experienced high inflation and high unemployment
simultaneously.
Copyright © 2010 Cengage Learning
Figure 6 The Breakdown of the Phillips Curve
Copyright©2010 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• Historical events have shown that the short-run
Phillips curve can shift due to changes in
expectations.
• The short-run Phillips curve also shifts because of
shocks to aggregate supply.
• Major adverse changes in aggregate supply can
worsen the short-run trade-off between
unemployment and inflation.
• An adverse supply shock gives policy makers a less
favourable trade-off between inflation and
unemployment.
Copyright © 2010 Cengage Learning
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• A supply shock is an event that directly alters
the firms’ costs, and, as a result, the prices they
charge.
• This shifts the economy’s aggregate supply
curve. . .
• . . . and as a result, the Phillips curve.
Copyright © 2010 Cengage Learning
Figure 7 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 favourable trade-off
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
Copyright©2010 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• In the 1970s, policymakers faced two choices
when OPEC cut output and raised worldwide
prices of oil.
• Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
• Fight inflation by contracting aggregate demand
and endure even higher unemployment.
Copyright © 2010 Cengage Learning
Figure 8 The Supply Shocks of the 1970s
Copyright©2010 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, the central bank has to
pursue contractionary monetary policy.
• When the central bank 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.
Copyright © 2010 Cengage Learning
Figure 9 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.
Copyright©2010 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, an economy must endure a period of
high unemployment and low output.
• When the central bank combats inflation, the economy
moves down the short-run Phillips curve.
• The economy experiences lower inflation but at the cost of
higher unemployment.
• The sacrifice ratio is the number of percentage points of annual
output that is lost in the process of reducing inflation by one
percentage point.
• A typical estimate of the sacrifice ratio is around 3 to 5.
• To reduce inflation from about 22% in early 1980 to 5%
would have required an estimated sacrifice of more than
40% of annual output!
Copyright © 2010 Cengage Learning
Rational Expectations and the Possibility of
Costless Disinflation
• The theory of rational expectations suggests that
people optimally use all the information they have,
including information about government policies,
when forecasting the future.
• 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 trade-off disappears
depends on how quickly expectations adjust.
• The theory of rational expectations suggests that the
sacrifice-ratio could be much smaller than estimated.
Copyright © 2010 Cengage Learning
The Thatcher Disinflation
• When Margaret Thatcher was elected Prime
Minister of the UK in 1979, inflation was
widely viewed as one of the nation’s foremost
problems.
• Inflation was reduced from almost 20 per cent
in 1980 to about 5 per cent in 1983, but at the
cost of high unemployment (about 11 per cent
in 1982 and 1983 ).
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Figure 10 The Thatcher Disinflation
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INFLATION TARGETING
• The Thatcher government in the early 1980s announced a
credible commitment to achieving targets for the growth of
money supply.
• However, a series of financial sector reforms that the
government introduced at the same time made the achievement
of these targets much more difficult than anticipated.
• Towards the end of the 1980s the government began to think of
other indicators of the tightness of monetary policy, such as the
exchange rate. In 1990 the UK joined the exchange rate
mechanism (ERM).
• In 1992, the UK was forced to withdraw from the ERM,
following a massive speculative attack on the pound.
• As a result, the government had to re-assess the tools and
indicators of monetary policy it should use.
Copyright © 2010 Cengage Learning
INFLATION TARGETING
• The level of the money supply and the exchange
rate can be thought of as intermediate targets of
monetary policy.
• The only final target of monetary policy is
inflation.
• Neither the money supply or the exchange rate are
under the direct control of the government.
• The implication is that the government should
target the rate of inflation directly and use interest
rates to achieve the target.
Copyright © 2010 Cengage Learning
INFLATION TARGETING
• Because it takes time for a change in interest
rates to affect the rate of inflation, the future
rate of inflation must be forecast and interest
rate changes made in advance of rises in
inflation.
• This is the approach adopted in the UK in late
1992.
Copyright © 2010 Cengage Learning
Summary
• The Phillips curve describes a negative relationship
between inflation and unemployment.
• By expanding aggregate demand, policy makers can
choose a point on the Phillips curve with higher inflation
and lower unemployment.
• By contracting aggregate demand, policy makers can
choose a point on the Phillips curve with lower inflation
and higher unemployment.
• The trade-off between inflation and unemployment
described by the Phillips curve holds only in the short run.
• The long-run Phillips curve is vertical at the natural rate of
unemployment.
Copyright © 2010 Cengage Learning
Summary
• The short-run Phillips curve also shifts because of
shocks to aggregate supply.
• An adverse supply shock gives policy makers a less
favorable trade-off between inflation and
unemployment.
• When the central bank contracts growth in the money
supply to reduce inflation, it moves the economy along
the short-run Phillips curve.
• This results in temporarily high unemployment.
• The cost of disinflation depends on how quickly
expectations of inflation fall.
Copyright © 2010 Cengage Learning