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Chapter 12
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Chapter 12: The Phillips Curve and Expectations
J. Bradford DeLong
http://www.j-bradford-delong.net/
[email protected]
12,657 words
Questions
What is Okun’s law?
What is the Phillips curve?
What determines the position of the Phillips curve?
What determines the slope of the Phillips curve?
How has the natural rate of unemployment changed in the U.S. over the past two
generations?
What significant supply shocks have affected the rate of inflation in the U.S. over the
past two generations?
What determines the expected rate of inflation?
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How can anyone tell how expectations of inflation are formed--whether they are
static, adaptive, or rational?
What difference does it make whether expectations of inflation are static, adaptive, or
rational?
How useful is the aggregate demand-aggregate supply framework--the IS-LM model
and the Phillips curve--for understanding macroeconomic events in the U.S. over the
past two generations?
How do we connect up the sticky-price model of this section, section IV, with the
flexible-price model of section III?
This chapter has two major goals: to complete the construction of the sticky-price model
begun in chapter 9, and to link up the sticky-price model analysis begun in chapter 9 with
the flexible-price model analysis of chapters 6 through 8. The key tool in both of these is
the Phillips curve: the relationship between inflation and unemployment according to
which a higher rate of unemployment is associated with a lower rate of inflation. The
Phillips curve is a way of looking at aggregate supply that happens to be the most
convenient way most of the time. Understand the Phillips curve—what it is, and how and
why it shifts—and there will be little in the short- and medium-run behavior of the
macroeconomy that you cannot analyze and understand.
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12.1 Output and Unemployment: Okun’s Law
First, however, we need to spend a little more time on the relationship between aggregate
demand, real GDP, and the unemployment rate.So far in this book one of our key
variables, the unemployment rate, has been largely absent. In the long-run growth
chapters unemployment was not a significant factor. In the flexible-price model there
were no fluctuations in unemployment: wages and prices were flexible and labor supply
balanced labor demand.
But it is time to bring unemployment to center stage. What the unemployment rate is is
very simple. With real GDP Y and potential output Y*, the unemployment rate u is:
u  u * 0.4 
Y  Y * 
 Y * 
where u* is the natural rate of unemployment: the rate of unemployment when
production is equal to potential output, and when the expectations of inflation rate are
correct.
This equation has a name: Okun’s law. Arthur Okun was the economist who first
recognized how very strong this relationship was. Take the proportional gap between
potential output and real GDP: (Y*-Y)/Y*. Multiply it by 0.4. Add to it the natural rate of
unemployment. The result is the current rate of unemployment. Conversely, take the
unemployment rate, subtract the natural rate of unemployment, and multiply by –2.5. The
result the output gap, the proportional gap between real GDP and potential output:
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Y Y*
 2.5  u  u *
Y*
It can be more useful to write Okun’s law in “change” form. If real GDP grows faster
than potential output, unemployment falls. If real GDP grows slower than potential
output, unemployment rises. Once again using the Greek letter capital delta  as a symbol
for “change”:
Y
u  0.4    (n  g)
Y *

Y
 (n  g)  2.5  u
Y*
where u is the year-to-year change in the unemployment rate, Y/Y* is annual growth
in real GDP (as a proportion of potential output), and n+g is the rate of growth of
potential output from chapter 4.
The strength of Okun's law allows economists to switch back and forth between talking
about business cycles as fluctuations in unemployment relative to the natural rate of
unemployment, and talking about business cycles as fluctuations in total production
relative to potential output. There is no significant distinction between the two: there is
no point in distinguishing “unemployment business cycles” in any way from “real GDP
business cycles.”
Box 12.1—Example: Calculating Unemployment from Output
Suppose that you know that the current level of potential output is $10 trillion and
that the current natural rate of unemployment is 5%. If someone asked you what
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the rate of unemployment would be if current real GDP were equal $10.5 trillion,
you could quickly calculate the answer from Okun’s law:
u  u * 0.4 
Y  Y * 
 Y * 
Start by calculating the output gap, the proportional difference (Y-Y*)/Y*
between real GDP and the economy’s level of potential output. The output gap is
5%:
Y  Y *  $10.5  $10 
 5%
 Y *   $10

Substituting this value of the output gap and the current natural rate of
unemployment into the Okun’s law equation for unemployment gives us the
current unemployment rate of 2.5 percent:
4.5%  0.4  5%  2.5%
We could equally well have started from the current unemployment rate of 2.5%
and the natural unemployment rate of 4.5% to calculate the output gap, and then
the current level of real GDP from the alternative form of Okun’s law:
Y Y*
 2.5  u  u *
Y*
by substituting in and obtaining a value of 5% for the output gap:
2.5  2.5%  4.5%  5% 
Y Y *
Y*
Which for a level of potential output Y* of $10 trillion corresponds to a value of
real GDP of $10.5 trillion.
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Box 12.2—Details: The Strength of Okun’s Law
The close association between the growth of real GDP (relative to the growth of
potential output) and changes in the unemployment rate makes Okun’s law one of
the strongest and most reliable of macroeconomic relationships. It means that we
can talk about fluctuations in unemployment and know that we are also talking
about fluctuations in real GDP relative to potential output. It means that we can
talk about fluctuations in real GDP relative to potential output and know that we
are also talking about fluctuations in unemployment.
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Figure Legend: Before 1974 the rate of real GDP growth that kept the
unemployment rate constant was about 4 percent per year. Between 1974
and 1995 or so the unemployment rate was constant when real GDP
growth was about 2.8 percent per year. Since 1995 the old, pre-1974
relationship has reemerged. The rate of output growth at which the
unemployment rate is constant is the rate of growth of potential output.
Source: 1999 edition of the Economic Report of the President
(Washington,
DC: Government Printing Office).
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Box 12.3—Economic Policy: Costs of High Unemployment
In a typical post-World War II U.S. recession, unemployment rises by two
percentage points—from around 5 percent to around 7 percent. Okun's law
predicts that, in such a case, total production relative to potential output falls by
about 5%. That's about four years' worth of growth in output per worker. And
recessions are not permanent: they are quickly over, and are followed by periods
of rapid growth that usually serve to return total output to its pre-recession growth
trend.
Even the steepest recession—that of 1982—raised the unemployment rate by only
four percentage points, and lowered output relative to potential by ten percent at
most—about seven years’ worth of economic growth. And within three years of
1982 unemployment had fallen back to what people then considered “normal”
levels.
Yet people fear a typical recession much more than they value an extra four years'
worth of economic growth. The memory of the 1982 recession has substantially
altered Americans’ perceptions of how the economy works, how much they dare
risk in the search for higher wages, and how confident they can be that their jobs
are secure.
Why do episodes of high recessionary unemployment have such a psychological
impact? The most likely answer is that recessions are feared because recessions
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do not distribute their impact equally. Workers who keep their jobs are only
lightly affected, while those who lose their jobs suffer a near-total loss of income.
People fear a 2% chance of losing half their income much more than they fear a
certain loss of 1%. Thus it is much worse for 2% of the people each to lose half of
their income than for everyone to lose 1%. It is the unequal distribution of the
costs of recessions that makes them so feared—and that makes voters so anxious
to elect economic policymakers who will successfully avoid them.
12.2 Inflation, Aggregate Supply, and the Phillips Curve
12.2.1 Three Faces of Aggregate Supply
When real GDP is greater than potential output, inflation is likely to be higher than
people had previously expected. Economists interpret this correlation between the
deviation of real GDP from potential output and the rate of inflation relative to its
previously-expected value using the idea of aggregate supply.
We can see this correlation as a relationship between the price level (relative to the
previously-expected price level) and the level of real GDP (relative to potential output):
 P  P e 
Y Y*
   
 P e 
Y*
We can see this correlation as a relationship between the inflation rate (relative to the
previously-expected inflation rate) and the level of real GDP (relative to potential output).
Inflation this year minus what inflation had been expected to be is the same as the
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proportional difference between the price level and what the price level had been
expected to be:
Y Y*
e
      
Y*
Or can use Okun’s law to write down yet a third form for short-run aggregate supply.
Real GDP relative to potential output is proportional to the difference between the
unemployment rate and the natural rate of unemployment. Substitute the unemployment
rate in on the left-hand side oft the equation above to come up with a relationship
between unemployment (relative to the natural rate of unemployment) and inflation
(relative to the previously-expected inflation rate):
1 
u  u*        e 
 
where the parameter (1/) is equal to (/2.5), and with u* standing for the natural rate of
unemployment—the unemployment rate when real GDP equals potential output. Rewrite
this formula with the inflation rate on the left-hand side as:
      (u  u*)
e
This is the Phillips curve (after the New Zealand economist A.W. Phillips who first wrote
back in the 1950s of the relationship between unemployment and the rate of change of
prices).
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Figure 12.1: The Phillips Curve
Inflation
Rate
Expected
Inflation
Unemployment Relative to
Its Natural Rate
Natural Rate
Legend: When inflation is higher than expected inflation and production is higher
than potential output, the unemployment rate will be lower than the natural rate of
unemployment. There is thus an inverse relationship in the short run between
inflation and unemployment: the lower unemployment, the higher inflation.
The Phillips curve tells you that if unemployment is below its natural rate, inflation π will
be higher than the previously-anticipated expected rate of inflation πe. The Phillips curve
turns out to be the most convenient of the three forms in which to look at aggregate
supply. But no matter which of the forms of the aggregate supply relationship you look
at, the underlying concepts are the same.
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Figure 12.2: Three Faces of Aggregate Supply
Aggregate Supply--Price Level Form
...subtract off the
price level to
get the....
Price
Level
Aggregate Supply--Inflation Form
Inflation
Rate
Expected
price
level
Expected
inflation
Potential
output
Real GDP Relative
to Potential Output
Potential
output
Real GDP Relative
to Potential Output
...use Okun's law to get the...
Phillips Curve
Inflation
Rate
Expected
inflation
Natural
rate of
unemployment
Unemployment Rate
Legend: You can think of aggregate supply either as a relationship between
production (relative to potential output) and the price level, between production
(relative to potential output) and the inflation rate, or between unemployment
(relative to the natural rate of unemployment) and the inflation rate. These are
three
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different views of what remains the same single relationship.
Box 12.4—Details: From Aggregate Supply to the Phillips Curve
Suppose that we start from an aggregate supply curve:
 P  P e 
Y Y*
   
 P e 
Y*
for which the parameter q equals 5: a one percentage-point rise in the price level
(relative to what was previously expected) is associated with a 5 percent increase
in real GDP relative to potential output:
P  P e 
Y Y*
 5   e
 P 
Y*
How do we translate this into a slope for the Phillips curve? First, we recognize
that the proportional difference between the price level P and the previouslyexpected price level Pe is the same as the difference between the inflation rate π
and the previously-expected inflation rate πe:
Y Y*
e
 5     
Y*
Second, we recognize that the proportional deviation between real GDP Y and
potential output Y* is –2.5 times the difference between the unemployment rate
and the natural rate of unemployment:
u * u 
5
e
    
2.5
Rewrite this to put the current inflation rate by itself on the left-hand side:
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   e  0.5  u  u *
and we are done
12.2.2 The Timing of the Phillips Curve
The Phillips curve relates this year's inflation to last year's unemployment. The typical
firm responds to stronger demand first by hiring workers (reducing unemployment) and
by working more hours. Only later do firms raise prices more rapidly. Quantities adjust
first. Prices adjust later.
Figure 12.3: The Timing of the Phillips Curve
Change in
real interest
rate
Change in
real GDP
...12 to 18
months
later...
...12 to 18
months
later...
Change in
the
inflation
rate
Legend: In our diagrams and equations, we implicitly assume that everything
happens at the same time. But in the real world that is not the case.
Changes in interest rates affect real GDP with a substantial lag as well. It takes time for
changes in interest rates to change the minds of business investment committees. It takes
more time for investment spending to change. And it takes still more time for changes in
investment spending to have their full effect on aggregate demand through the multiplier.
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Timing is important for making policy and making forecasts. Timing is less important for
understanding the structure of the economy. So often, to keep things simpler, we will
neglect these timing considerations.
12.2.3 The Working of the Phillips Curve
The slope of the Phillips curve depends on how sticky wages and prices are. The stickier
are wages and prices, the smaller is the parameter  and the flatter is the Phillips curve.
The position of the Phillips curve is determined by the natural rate of unemployment and
the expected rate of inflation. Whenever unemployment is equal to its natural rate,
inflation is equal to expected inflation as long as there are no current supply shocks. For
adverse supply shocks--the kind of real shocks discussed in the last section of chapter 7-can and do spill over and affect aggregate supply.
Thus the final, complete form of the Phillips curve equation is:
   e   (u  u*)   s
The rate of inflation π is equal to expected inflation πe, minus  times the difference
between actual and the natural rate of unemployment, plus a term s for supply shocks.
The parameter  varies widely. In the U.S. today it is about 0.5. The current natural rate
of unemployment u* is between 4.5 and 5 percent.
A higher natural rate moves the Phillips curve right. Higher expected inflation moves the
Phillips curve up. Adverse supply shocks (like the 1973 tripling of world oil prices) move
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the Phillips curve up. Favorable supply shocks (like the 1986 worldwide declines in oil
prices) move the Phillips curve down.
Figure 12.4: Shifts in the Phillips Curve
Phillips Curve
Phillips Curve
Inflation
Rate
Inflation
Rate
Expected
inflation
Expected
inflation
Unemployment Rate
Natural
rate of
unemployment
Natural
rate of
unemployment
Unemployment Rate
Legend: When expected inflation changes, the position of the Phillips Curve
changes too.
If the past forty years have made anything clear, it is that the Phillips curve shifts around
substantially both as expected inflation changes and as the natural rate changes. Neither is
a constant. Both are variables whose behavior must be explained.
12.3 Aggregate Demand and Inflation
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The previous chapters of section IV set out those pieces of the sticky-price model that
determined real GDP. This chapter so far has detailed the Okun’s law relationship
between real GDP and unemployment and has set out the key aggregate supply
relationship that is the Phillips curve. So it is now time to bring these two pieces together:
to show, quantitatively and explicitly, how the sticky-price model allows you to calculate
not just real GDP but the unemployment rate and the inflation rate as well.
The most straightforward way to accomplish this is to draw on the Taylor-rule monetary
policy reaction function of the previous chapter: Stanford economist John Taylor’s
observation that modern central banks set the real interest rate according to:
r  r * '' (  ' )
The central bank has a target value for what it would like inflation to be π’, and an
estimate of the normal real interest rate r*. It raises interest rates above r* if inflation is
higher than its target value. If we combine the IS curve with this Taylor rule and define
Y0 to be the level of real GDP when the real interest rate is at its long-run normal value
r*, then as we saw in the last chapter this monetary policy reaction function relationship
between output and inflation is the simple-looking:
Y  Y0   ' (  ' )
where the parameter ’ is:
' 
"Ir  X  r 
1  MPE
the product of the slope of the IS curve and the amount by which the central bank raises
interest rates when inflation rises.
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But what we really want is an equation with the unemployment rate on the left-hand side.
The Phillips curve relationship between unemployment and inflation is our most
convenient way of looking at aggregate supply. So define u0 to be the unemployment rate
when real GDP is equal to Y0, and use Okun’s law to substitute the unemployment rate
on the left-hand side:
u  u0    (  ' )
of the monetary policy reaction function equation. The new parameter  is equal to the
old parameter ’/2.5. This together with the Phillips curve equation:
   e   (u  u*)   s
enables you to solve for the inflation and unemployment rates in the economy. Simply
substitute the Phillips curve equation into the monetary policy reaction function equation
for the inflation rate, and substitute the monetary policy reaction function into the Phillips
curve for the unemployment rate:
   e   ' 
u0


u


 u* 
 s
1 
1 
1  
1 

  u * u0 
e

s


 ' 
1  
1  
1 
1 
The unemployment rate depends on:

u0, which is Okun’s law combined with the position of the IS curve: what the
unemployment rate would be if the real interest rate were equal to its long-run
normal value r*. Think of u0 as the index of the normal interest rate level of
aggregate demand.
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The difference between the expected rate of inflation πe and the central bank’s target
rate of inflation π’.

The current natural rate of unemployment u*.

Supply shocks.

The parameters and : the product of the slope of the IS curve with the central
bank’s propensity to raise interest rates when inflation rises, and the slope of the
Phillips curve.
If the central bank lowers its target rate of inflation or if expected inflation rises, the
unemployment rate would rise. If changes in the economic environment or in economic
policy raise the unemployment rate u0 corresponding to the “normal” interest rate r*, the
unemployment rate would rise. If the natural rate of unemployment u* rises,
unemployment will rise. And adverse supply shocks will also cause higher
unemployment.
The inflation rate depends on:

Expected inflation.

The difference between the natural rate of unemployment u* and what unemployment
would be if the interest rate were equal to r*.

The central bank’s target for inflation.

Supply shocks.

The parameters and : the product of the slope of the IS curve with the central
bank’s propensity to raise interest rates when inflation rises, and the slope of the
Phillips curve.
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If expected inflation rises, the inflation rate will rise. If the difference between the natural
rate of unemployment and the unemployment rate corresponding to the normal interest
rate r* rises, inflation will rise. If the central bank raises its target rate of inflation π’,
inflation will rise. And adverse supply shocks will also cause higher inflation.
Note that here we have examined only one of our three ways of looking at aggregate
supply (albeit our preferred way, the Phillips curve way). We could also have looked,
instead, for the analogous formulas determining inflation and the level of real GDP, or for
the analogous formulas determining the price level and the level of real GDP.
Figure 12.5: Aggregate Demand and Supply When Demand Depends on the
Inflation Rate
Aggregate Supply--Price Level Form
Aggregate Supply--Inflation Form
Price
Level
Expected
price
level
Expected
inflation
Potential
output
Real GDP Relative
to Potential Output
Phillips Curve
Inflation
Rate
Inflation
Rate
Expected
inflation
Potential
output
Real GDP Relative
to Potential Output
Unemployment Rate
Natural
rate of
unemployment
Aggregate Demand
Legend: This section only showed explicitly how to calculate the equililbrium
inflation rate and unemployment rate produced by the interaction of the Phillips
curve and the monetary policy reaction function. But this was only one of our
three
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ways of looking at aggregate supply. Similar analyses would allow you to
calculate
the equilibrium inflation rate and level of real GDP, or the equilibrium price level
and level of real GDP.
Box 12.5—Details: From Income-Expenditure to Aggregate Demand-Aggregate
Supply
The slope of the Phillips curve parameter, , has little lying “underneath” it. We
can say little about the deeper parameters and functions that determine it. The
most we can say is that  = 0.4/, where  is the proportional amount of extra
productive effort called forth by a surprise one percent rise in the price level. Each
of the competing theories of aggregate supply mentioned in chapter 11 hopes
someday to account for why this parameter  is what it is. But none would claim
to be able to do so yet
By contrast, an enormous amount of detail—four chapters’ worth—underpins the
parameter , the slope of the monetary policy reaction function.
u  u0    (  ' )
We can see this by simply writing out and expanding our equation for what  is:

1
1
 "Ir  X  r  
2.5
1  Cy  (1  t)  IMy 
This equation has four distinct terms, each of which has taken up considerable
space in the past four chapters.
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The first term:
1
2.5
comes from the Okun’s law section at the start of this chapter. It is the change in
the unemployment rate produced by a one percent change in real GDP relative to
potential output.
The second term:
"
comes from the discussion of central banker aversion to inflation in chapter 11. It
is the amount by which central bankers raise the real interest rate when inflation
turns out to be one percent per year higher.
The third term:
Ir  X   r 
comes from chapter 10. It is the amount by which autonomous spending changes
when the real interest rate changes. It incorporates both the effect of interest rates
on investment spending, and the effect of interest rates on the exchange rate and
hence on exports spending too.
The fourth and last term:
1
1  Cy  (1  t)  IMy 
Comes from chapter 9. It is the multiplier—one divided by one minus the MPE,
the marginal propensity to expend extra income on domestically-produced goods.
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There is a sense in which most of the work of the preceding three chapters (and of
this one) is encapsulated in this single parameter , the slope of the monetary
policy reaction function.
12.4 The Natural Rate of Unemployment
The natural rate of unemployment shifts over time as the demography of the labor force,
the institutions that govern job search and wage bargaining, and other frictions and
factors in the economy change. Today, most estimates of the current U.S. "natural" rate
lie between 4.5 and 5.0 percent. All economists, however, agree that the uncertainty
about the level of the natural rate of unemployment is great.
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Figure 12.6: Fluctuations in Unemployment and the Natural Rate [to be updated
every year]
Legend: The natural rate of unemployment is not fixed. It varies substantially
from
decade to decade. Moreover, variations in the natural rate in the United States
have
been much smaller than variations in the natural rate in other countries.
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"Natural" normally carries strong positive connotations of normal and desirable. But a
high natural rate of unemployment--a rate below which unemployment cannot be reduced
without accelerating inflation--is a bad thing. A high natural rate means that expansionary
fiscal and monetary policy are largely ineffective as tools to permanently reduce
unemployment.
12.4.1 Demography and the Natural Rate
Even without changes in how the labor market operates, the economy's natural rate of
unemployment will change as changing demography changes the relative age and
educational distribution of the labor force. Teenagers have higher unemployment rates
than adults. Thus an economy with a lot of teenagers will have a higher natural rate. More
experienced and more skilled workers find looking for a job an easier experience. They
take less time to find a new job when they leave an old one. Thus the natural rate of
unemployment will fall when the labor force becomes more experienced and more
skilled. Women used to have higher unemployment rates than men--although this is no
longer true in the U.S. The more educated tend to have lower rates of unemployment than
the less well educated. And African-Americans have higher unemployment rates than
whites.
Some part of the rise in the natural rate from 5 percent or so in the 1960s to 6 to 7 percent
at the end of the 1970s was due to changing demography. Some of the decline in the
natural rate since was due to the increasing experience at searching for jobs of the very
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large baby-boom cohort. But the exact, quantitative relationship between demography
and the natural rate is not well understood.
12.4.2 Institutions and the Natural Rate
Some economies have strong labor unions; other economies have weak ones. Some
unions sacrifice employment in their industry for higher wages; others settle for lower
wages in return for employment guarantees. Some economies lack apprenticeship
programs that make the transition from education to employment relatively
straightforward; others make the school-to-work transition easy. Of each pair, the first
increases and the second reduces the natural rate of unemployment. Barriers to worker
mobility raise the natural rate, whether the barrier be subsidized housing that workers
lose if they move (as in Britain in the 1970s and the 1980s), or high taxes that a firm must
pay to hire a worker (as in France from the 1970s to today).
However, the link between economic institutions and the natural rate is neither simple nor
straightforward. The institutional features many observers today point to as a source of
high European unemployment now were also present in the European economies in the
1970s--when European unemployment was low. Once again the quantitative relationships
are not well understood.
12.4.3 Productivity Growth and the Natural Rate
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In recent years it has become more and more likely that a major determinant of the
natural rate is the rate of productivity growth. The era of slow productivity growth from
the mid-1970s to the mid-1990s saw a relatively high natural rate. By contrast, rapid
productivity growth before 1973 and after 1975 seems to have generated a low natural
rate.
Why should a productivity growth slowdown generate a high natural rate? A higher rate
of productivity growth allows firms to pay higher real wage increases and still remain
possible. If workers' aspirations for real wage growth themselves depend on the rate of
unemployment, then a slowdown in productivity growth will increase the natural rate. If
real wages grow faster than productivity for an extended period of time, profits will
disappear. Long before that point is reached businesses will begin to fire workers, and
unemployment will rise.
Thus if productivity growth slows unemployment will rise. Unemployment will keep
rising until workers' real wage aspirations fall to a rate consistent with current
productivity growth.
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Figure 12.7: Real Wage Growth Aspirations and Productivity
Real wage
growth
"Warranted" real wage growth imposed by
rate of productivity growth
Workers ' as pirations for real wage growth
Unemployment rate
Natural rate
of unemployment
Legend: Workers aspire to earn higher real wages. How much workers demand in
the way of increases in the average real wage is a function of unemployment: the
higher is unemployment, the lower are workers' aspirations for real wage growth.
But in the long run real wages can grow no faster than productivity. Hence the
natural rate of unemployment is whatever rate of unemployment curbs real wage
demands so that they are consistent with productivity growth.
12.4.4 The Past Level of Unemployment and the Natural Rate
Last, the natural rate will be high if unemployment has been high. Before 1980 Western
European economies had unemployment rates lower than the 5% to 6% that the U.S.
averaged back then. But the mid-1970s brought recessions. European unemployment
rose, but did not fall back much in subsequent recoveries. Cyclical unemployment had
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been allowed to persist until it turned into structural unemployment: Workers left
unemployed for two or three years had lost their skills, lost their willingness to show up
on time, and lost their interest in even looking for new jobs. Thus the natural rate rose
sharply in Europe with each business cycle. In the 1960s stable inflation was
accompanied by a mere 2% unemployment rate in Europe; by the mid-1990s European
unemployment averaged 8% and inflation was stable.
Figure 12.8: The Rise in European Unemployment
Legend: The growth of unemployment in fifteen western European countries,
19601995. (ESP = Spain; FIN = Finland; BEL = Belgium, IRE = Ireland; ITA = Italy;
FRA = France; DEU = Germany; NLD = Netherlands; NOR = Norway; AUT =
Austria; SWE = Sweden; CHE = Switzerland.)
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Source: Olivier Blanchard and Justin Wolfers (2000), “The Role of Shocks and
Institutions in the Rise of European Unemployment” (Cambridge: NBER
Working
Paper 7282).
Why does high unemployment lead to a high natural rate? The most important reason is
that high unemployment generates long-term unemployment. By the late 1990s perhaps
half of the unemployed in Europe had been unemployed for more than a year. The human
cost of long-term unemployment is much greater than the cost of short-term
unemployment. It is painful and depressing to be unemployed for more than a year. The
long-term unemployed lose their attachment to the labor force, their work habits, and
their skills. Thus employers become unwilling to hire the long-term unemployed. And as
their skills and attachment to the labor force continue to deteriorate, the downward spiral
continues.
When the long-term unemployed become completely unemployable in the eyes of
managers, they might as well not be there as far as the process of wage and price
determination is concerned. To the extent that the long-term unemployed lack skills and
employability, each addition to the stock of the long-term unemployed becomes an
addition to the natural rate.
This laundry list of factors affecting the natural rate is incomplete. Do not think that
economists' understand much about why the natural rate is what it is. Almost every
economist was surprised by the large rise in the natural rate in western Europe over the
past quarter century. Almost every economist was surprised by the sharp fall in
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America’s natural rate in the 1990s. And economists cannot confidently account for these
shifts even in retrospect.
12.5 Expected Inflation
The natural rate of unemployment and expected inflation determine the location of the
Phillips curve--whether it is high or low, whether it is shifted to the left or to the right.
The Phillips curve passes through the point on the graph where inflation is equal to
expected inflation and unemployment is equal to its natural rate of unemployment. A
higher natural rate of unemployment moves the Phillips curve to the right. Higher
expected inflation would move the Phillips curve upward. But who does the expecting?
And when do people form expectations relevant for this year's Phillips curve?
Figuring out the expected inflation term in the Phillips curve must be is perhaps the
hardest part of any Phillips curve analysis. Expected inflation depends in some way on
what inflation is going to be. There is a potential feedback loop: causes having
consequences, and then the consequences pursuing the causes back through time to affect
them in turn. People's expectations of the future are key. Their images of the future shape
their actions now. Thus the current economy depends on what people think the future will
be. This makes economics genuinely hard.
12.5.1 Kinds of Expectations
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Economists work with three basic scenarios for how managers, workers, and investors go
about forecasting the future and forming their expectations:
Static expectations. Static expectations of inflation prevail when people ignore the fact
that inflation can change.
Adaptive expectations. Adaptive expectations prevail when people assume the future
will be like the recent past.
Rational expectations. Rational expectations prevail when people use all the information
they have as best they can.
The Phillips curve behaves differently under each of these three scenarios.
12.5.2 The Phillips curve Under Static Expectations
If inflation expectations are static, expected inflation never changes. People just don’t
think about inflation. As long as the natural rate of unemployment remains unchanged
(an important qualification) and as long as there are no substantial supply shocks (another
important qualification) the Phillips curve is static as well. There will be some years in
which unemployment is relatively low; in those years inflation will be relatively high.
There will be other years in which unemployment is higher, and then inflation will be
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lower. But as long as expectations of inflation remain static, the trade-off between
inflation and unemployment will not change from year to year.
Figure 12.9: Static Expectations of Inflation
Inflation
Rate
Static
expected
inflation
Natural
rate of
unemployment
Unemployment Rate
Low unemployment goes
with high--but not rising-inflation
High unemployment goes
with low--but not falling-inflation
Legend: If inflation expectations are static, the economy moves up and to the left
and down and to the right along a Phillips curve that does not change its position.
If inflation has been low and stable, businesses will probably hold static inflation
expectations. Why? Because the art of managing a business is complex enough as it is.
Managers have a lot of things to worry about: what their customers are doing, what their
competitors are doing, whether their technology is adequate, and how applicable
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technology is changing. When inflation has been low or stable, everyone has better things
to focus their attention on than the rate of inflation.
Box 12.6--Example: Static Expectations of Inflation in the 1960s
The standard example of static expectations is expectations of inflation in the
1960s. No matter whether inflation in any year was lower or higher, rising or
falling, economy-wide expectations of what inflation would be in the future were
unchanged. For example, in the 1960s the American economy moved along a
static short-run Phillips curve. When unemployment was above 5.5%, inflation
was below 1.5%. When unemployment was below 4%, inflation was above 4%.
Static inflation expectations meant that this Phillips curve did not shift up or down
during that decade. Instead, the economy moved up and to the left and down and
to the right along what appeared to be a stable Phillips curve of constant slope.
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Figure: Static Expectations and the Phillips Curve in the 1960s
This led economists, politicians, and central bankers to ask, Why not use
expansionary monetary and fiscal policy to keep the economy at the upper left
corner of the Phillips curve, with permanently low unemployment? In the midand late-1960s economic policy successfully moved the economy to the lower
right end of the (then-static) Phillips curve. And economists, politicians, and the
rest of us then learned the answer to this question.
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Inflation expectations remained static--and the Phillips curve unchanged--only
when inflation was low and steady: When inflation rose and became more
variable, firms and workers began changing their expectations to adaptive ones,
and the Phillips curve shifted upward.
12.5.3 The Phillips Curve Under Adaptive Expectations
Suppose that the inflation rate varies too much for workers and businesses to ignore it
completely. Everyone agrees that if you rely on static expectations you are going to make
big mistakes in the prices you charge or the prices you pay. What then? As long as
inflation last year is a good guide to what inflation will be this year, workers and
managers are likely to hold adaptive expectations. They form their forecasts of this year's
expected inflation by setting them equal to what last year's actual inflation happened to
be. Such adaptive expectations are a good rule-of-thumb for two reasons. First, adaptive
forecasts are good forecasts: as long as inflation changes only slowly, you don’t make big
errors by assuming that this year is likely to be very similar to last year. Second, adaptive
expectations are simple: you don’t waste a lot of time and energy forming your inflation
expectations.
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Figure 12.10: The Phillips Curve Under Adaptive Expectations
Inflation
Rate
Expected inflation = last-year's inflation
Natural
rate of
unemployment
Unemployment Rate
Low unemployment goes
with higher than expected
inflation
High unemployment goes
with lower than expected
inflation
Legend: If inflation expectations are adaptive, then changes in inflation shift the
position of the Phillips curve: last year's actual rate of inflation becomes this
year's
expected inflation. Thus a low rate of unemployment not only leads to relatively
high inflation this year, it shifts next year’s Phillips curve upward as well.
Under such adaptive inflation expectations we need to add time subscripts so that we
know what year we are talking about. And the equation for the Phillips curve becomes:
 t  t 1   (ut  ut *)   t
s
where πt-1 stands for the fact that expected inflation is just equal to inflation last year.
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Under such a set of adaptive expectations, the Phillips curve will shift up or down
depending on whether last year's inflation was higher or lower than the previous year's. A
value of unemployment lower than the natural rate will raise inflation. Higher inflation
will then raise expected inflation in the subsequent year, and in the year after that, and so
on. Under adaptive expectations, inflation accelerates when unemployment is less than
the natural unemployment rate. It decelerates when unemployment is more than the
natural rate. Hence this Phillips curve is sometimes called the accelerationist Phillips
curve.
Box 12.7--Example: A High-Pressure Economy Under Adaptive Expectations
For example, if the government tries to keep unemployment below the natural rate
for long in an economy with adaptive expectations, then year after year inflation
is likely to be higher than that year’s value of expected inflation--and so year after
year expected inflation will rise. The government will then find the short-run
Phillips curve steadily drifting upwards, and the price level will accelerate, with
each year’s proportional increase in prices greater than the last.
In algebra we can easily work out the consequences--which hold only as long as
expectations remain adaptive. Suppose that the government pushes the economy's
unemployment rate down two percentage points below the natural rate, that the 
parameter in the Phillips curve is 1/2, that there are no current supply shocks, and
that last year's inflation rate was 4%.
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4 + 1/2 x 2 = 5
Next year's inflation rate will be:
5 + 1/2 x 2 = 6
The following year's inflation rate will be:
6 + 1/2 x 2 = 7
The year after that's inflation rate will be:
7 + 1/2 x 2 = 8
Figure: Accelerating Inflation
Inflation
Rate
The following year's inflation = the year after that's expected inflation
Next year's inflation = the following year's expected inflation
This year's inflation = next year's expected inflation
The year after that's Phillips curve
Expected inflation = last year's inflation
The following year's Phillips curve
Next year's Phillips curve
This year's Phillips curve
Natural
rate of
unemployment
Unemployment Rate
The government holds
unemployment below
the natural rate
And so on and so forth. As long as expectations of inflation remain adaptive,
inflation will increase by one percent per year for every year that passes.
But expectations of inflation will not remain adaptive forever if the inflation rate
keeps rising and rising. Instead, the situation is likely to decay into hyperinflation
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unless the government abandons its attempt to keep unemployment lower than its
natural rate.
12.5.3.1 The Sacrifice Ratio
In an economy with adaptive expectations the government can shift the Phillips curve
downward--and thus create for the future a more favorable tradeoff between inflation and
unemployment--by generating a recession and pushing the unemployment rate up now.
Just as an adaptive expectations economy with unemployment below the natural rate sees
expectations of inflation rising year after year, so an adaptive expectations economy with
unemployment above the natural rate will see expectations of inflation falling year after
year.
Suppose that the current inflation rate last year was at a value π-1, and that the
government wanted, over the next two years, to reduce inflation to a value of zero. What
policies would it have to follow to achieve this goal? Let's reintroduce time subscripts to
keep track of what happens when, calling the current year year zero. The government
wants π2 to be equal to zero. What needs to be done to bring this about?
In this framework the current inflation rate is:
 0  1   (u0  u*)  ' (u0  u*)
Next year's inflation rate will be:
1  0  (u1  u*)
But if we substitute the expression for this year's inflation rate:
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1  1  (u0  u*)  (u1  u*)
Then inflation in year two will be:
 2  1   (u0 u*)  (u1  u*)   (u2  u*)
If inflation in year two is to equal its target level of zero, it must be the case that:
 1  0

 (u0  u*)  (u1  u*)  (u2  u*)
This equation tells us that if inflation is to be reduced to zero, unemployment must-sometime in the three years--be above its natural rate by an amount equal to (π-1)/.
Lowering inflation requires a period of high unemployment and reduced output. A cost of
1/ worth of higher unemployment for one year is required to permanently reduce
inflation by one percentage point. This is called the sacrifice ratio. A typical estimate of
the sacrifice ratio is--given the estimated value of --that it is equal to 2: an extra
two percentage points of unemployment must be incurred for one year (or an extra one
percentage point for two years) over and above the natural rate in order to reduce
inflation by one percentage point.
Box 12.8—Economic Policy: The Volcker Disinflation
Between 1979 and the mid-1980s, the Federal Reserve reduced inflation in the
United States from 9 percent per year to about 3 percent. At the end of the 1970s
the high level of expected inflation gave the United States an unfavorable shortrun Phillips curve tradeoff. By the middle of the 1980s the fall in inflation had
also generated a fall in expected inflation: expectations of inflation were adaptive.
And the fall in expected inflation had shifted down the short-run Phillips curve,
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giving the United States a much more favorable short-run inflationunemployment tradeoff.
Figure: The Phillips Curve Before and After the Volcker Disinflation
To accomplish this goal, the Federal Reserve raised interest rates sharply,
discouraging investment, reducing aggregate demand, and pushing the economy
to the right along the Phillips curve. Unemployment rose, and inflation fell.
Reducing annual inflation by 6 percentage points required "sacrifice": during the
disinflation unemployment averaged some 1 1/2 percentage points above the
natural rate for the seven years between 1980 and 1986. Ten percentage point-
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years of excess unemployment above the natural rate--that was the cost of
reducing inflation from near ten to below five percent.
[Figure: Change in the Phillips curve generated by the Volcker disinflation]
Box 12.9--Example: Accelerating Inflation
At the end of the 1960s, U.S. unemployment fell and stayed below the "natural"
rate for eight straight years, from 1966 through 1973. During those years,
inflation accelerated from 1.9% per year in 1965 to 5.6% per year in 1973. Year
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after year, unemployment was lower and aggregate demand higher than the
natural rate of unemployment, so inflation was higher than expected as well.
At some point early in this process, people shifted the process, people raised their
expectations of inflation, and the Phillips curve shifted upward. By 1973 a given
value of the unemployment rate was associated with 4% per year higher inflation
than it had been in the mid-1960s.
Figure: Accelerating Inflation at the End of the 1960s
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12.5.4 The Phillips Curve Under Rational Expectations
What happens government policy and the economic environment are changing rapidly
enough that adaptive expectations lead to significant errors, and are no longer good
enough for managers or workers? Then the economy will shift to “rational” expectations.
Under rational expectations, people form their forecasts of future inflation not by looking
backward at what inflation was, but by looking forward. They look at what current and
expected future government policies tell us about what inflation will be. Business
managers and workers then take into account what they learn about future policy. For
example, they would raise their expectations of future inflation should they learn that the
government is--as it did in the early 1970s—trying to pressure the Federal Reserve into
boosting demand to try to lower unemployment.
12.5.4.1 Economic Policy Under Rational Expectations
Under rational expectations the Phillips curve shifts as rapidly as, or faster than, changes
in economic policy that affect the level of aggregate demand. This has an interesting
consequence: anticipated changes in economic policy turn out to have no effect on the
level of production or employment.
Consider an economy that begins in equilibrium, with the aggregate demand relation
intersecting the Phillips curve--aggregate supply--at the point where inflation is equal to
expected inflation and unemployment is equal to its natural rate. Suppose that workers,
managers, savers, and investors have rational expectations. And suppose that the
government takes steps to stimulate the economy: it cuts taxes, increases government
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spending, or instructs the central bank to lower the real interest rate in order to reduce
unemployment below the natural rate. What is likely to happen?
Figure 12.11: The Government Attempts to Stimulate the Economy
Legend: A government pursuing an expansionary economic policy shifts the
aggregate demand curve. Remember that on the Phillips curve diagram an
increase
in production is associated with a reduction in unemployment, so an expansionary
shift is a shift to the left in Phillips-curve diagram aggregate-demand!
If the government's policy comes as a surprise--if the expectations of inflation that matter
for this year's Phillips curve have already been set, in the sense that the contracts have
been written, the orders have been made, and the standard operating procedures
identified--then the economy moves up and to the left along the Phillips curve in response
to the shift in aggregate demand produced by the change in government policy.
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Figure 12.12: If the Shift in Policy Comes as a Surprise…
Legend: A surprise expansionary policy shifts the economy up and to the left
along
the Phillips curve, raising inflation and lowering unemployment (and raising
production) in the short run.
But if the government's policy is anticipated--if the expectations of inflation that matter
for this year's Phillips curve are formed after the decision to stimulate the economy is
made and becomes public--then workers, managers, savers, and investors take the
stimulative policy into account when they form their expectations of inflation. Thus the
level of expected inflation after the shift in policy will be the actual level of inflation after
the policy shift. That means that the inward shift in aggregate demand will be
accompanied, under rational expectations, by an upward shift in the Phillips curve as the
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shift in aggregate demand leads to an increase in expected inflation. How large an
increase? An increase in expected inflation sufficient to make expected inflation after the
demand shift equal to actual inflation.
Figure 12.13: If the Shift in Policy Is Anticipated…
Legend: If the expansionary policy is anticipated, than workers, consumers,
and managers will build what the policy will do into their expectations: the
Phillips
curve will shift up as the aggregate demand curve shifts in, and so the
expansionary
policy will raise inflation without having any impact on unemployment (or
production).
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Thus an anticipated increase in aggregate demand has, under rational expectations, no
effect on the unemployment rate or on real GDP. Unemployment does not change: it
remains at the natural rate of unemployment because the shift in the Phillips curve has
neutralized in advance any impact of changing inflation on unemployment. It will,
however, have a large effect on the rate of inflation. Economists will sometimes say that
under rational expectations "anticipated policy is irrelevant." But this is not the best way
to express it. Policy is very relevant indeed for the inflation rate. It is only the effects of
policy on real GDP and the unemployment rate--effects that are associated with a
divergence between expected inflation and actual inflation--that are neutralized.
Box 12.10—Economic Policy: President Mitterand and France in 1981
In 1981 the French socialist Francois Mitterand won the presidential election by
promising to end the high-unemployment stagflation that had gripped the French
economy since 1973. Mitterand promised that his policies would lower
unemployment and inflation and restore rapid productivity growth. They claimed
to know how to reattain full employment through Keynesian economic stimulus
that would expand aggregate demand. Massive increases in government spending,
large budget deficits, and a redistribution of purchasing power from the (low
marginal propensity to consume) rich to the (high marginal propensity to
consume) poor would “reflate” the French economy.
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But Mitterand’s policy came two or three decades too late. By 1981 a decade of
high and variable inflation had made every French saver and every international
exchange rate speculator keenly aware that what the French inflation rate would
be depended on what the French government’s policies were. Mitterand had
preannounced his policies loudly and publicly: they were, after all, his election
platform. If ever there was a case in which there was good reason to believe that
expected inflation would be formed through rational expectations, it was France
in 1981.
So it came as little surprise to cynical outside observers—although it came as a
great surprise to the Mitterand administration itself—that the French Phillips
curve shifted upwards even as the new socialist government took office.
Unemployment in France did not fall. But inflation rose sharply. By the end of
1982 the Mitterand administration had reversed course nearly totally. The idea
that full employment could be reattained by expanding aggregate demand was
abandoned.
12.5.6 What Kind of Expectations Do We Have?
If inflation is low and stable, expectations are probably static: it is not worth anyone's
while to even think about what one's expectations should be. If inflation is moderate and
fluctuates, but slowly, expectations are probably adaptive: to assume that the future will
be like the recent past--which is what adaptive expectations are--is likely to be a good
rule of thumb, and is simple to implement.
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When shifts in inflation are clearly related to changes in monetary policy, swift to occur,
and are large enough to seriously affect profitability, then people are likely to have
rational expectations. When the stakes are high--when people think, "had I known
inflation was going to jump, I would not have taken that contract"--then every economic
decision becomes a speculation on the future of monetary policy. Because it matters for
their bottom lines and their livelihoods, people will turn all their skill and insight into
generating inflation forecasts.
Thus the kind of expectations likely to be found in the economy at any moment depend
on what has been and is going on. A period during which inflation is low and stable will
lead people to stop making, and stop paying attention to, inflation forecasts--and tend to
cause expectations of inflation to revert to static expectations. A period during which
inflation is high, volatile, and linked to visible shifts in economic policy will see
expectations of inflation become more rational. An intermediate period of substantial but
slow variability is likely to see many managers and workers adopt the rule-of-thumb of
adaptive expectations.
12.5.6.1 Persistent Contracts
The way that people make contracts and form and execute plans for their economic
activity are likely to make an economy behave as if expectations in it are less "rational"
than expectations in fact are. People do not wait until December 31 to factor next year's
expected inflation into their decisions and contracts. They make decisions about the
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future, sign contracts, and undertake projects all the time. Some of those steps govern
what the company does for a day. Others govern decisions for years or even for a decade
or more.
Thus the "expected inflation" that determines the location of the short-run Phillips curve
has components that were formed just as the old year ended, but also components that
were formed two, three, five, ten, or more years ago. People buying houses form
forecasts of what inflation will be over the next thirty years--but once the house is
bought, that decision is a piece of economic activity (imputed rent on owner occupied
housing) as long as they own the house, no matter what they subsequently learn about
future inflation. Such lags in decision making tend to produce "price inertia." They tend
to make the economy behave as if inflation expectations were more adaptive than they in
fact are. There will always be a large number of projects and commitments already
underway that cannot easily adjust to changing prices. It is important to take this "price
inertia" into account when thinking about the dynamics of inflation, output, and
unemployment.
12.5.7 Supply Shocks and the Inflation Rate
Sometimes there can be sudden increases in prices that suddenly push the Phillips curve
upward. In an economy with large amounts of imports and exports, a sudden reduction in
the value of the currency is such a supply shock. So was the rapid increase in the price of
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oil in 1973 and again in 1979--the so-called oil shocks. The large decrease in the price of
oil in 1986 was another supply shock, but this time in the opposite direction.
Figure 12.14: The Supply Shock of 1973
Legend: The sudden shift in the Phillips curve between 1973 and 1975 was the
result not of any change in inflation expectations but of a supply shock: the
tripling
of world oil prices.
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Such unfavorable supply shocks lead to what is called stagflation. Both inflation and
unemployment will rise as the economy moves to a new equilibrium up and to the right
on the Phillips curve diagram. If the Federal Reserve tries to accommodate the supply
shock by keeping it from reducing real GDP, it risks creating very high inflation. If the
Federal Reserve tries to keep the supply shock from raising prices and inflation, it risks a
very severe recession, fall in real GDP, and rise in unemployment.
12.6 Understanding Fluctuations in the U.S.
How useful is the Phillips curve in understanding economic fluctuations in the U.S. over
the past generation or so? If we plot on a graph the points corresponding to inflation and
unemployment attained by the U.S. economy since 1960, the economy has been all over
the map—or at least all over the diagram. Yet the Phillips curve is useful: that is why
macro courses spend time on it. It does provide a framework to understand what
happened--and is happening.
If we look at the track of unemployment and inflation in the U.S. over the past forty
years, we see a tangled picture that crosses and re-crosses itself over the decades. During
the first half of the period both unemployment and inflation are more likely than not to
drift upward. During the second half of the period both unemployment and inflation trend
downward. The position of the economy on the Phillips curve diagram also describes four
rough counterclockwise loops--from 1960 to 1972, from 1972 to 1977, from 1977 to
1987, and from 1987 to the present. The first two of these end with higher inflation and
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unemployment than they had started with. The last two of which end with lower inflation
and unemployment than they had started with.
In rough outline, the way to understand these loops is that each of them is composed of
four parts:

A period during which the economy moves up and to the left along a more-orless stable short-run Phillips curve as unemployment falls and inflation rises,
during which expansionary economic policies take hold in a context of
relatively stable inflation expectations.

A period during which the economy moves up and to the right and
unemployment and inflation both rise as the Phillips curve shifts out, in part
because of a rising natural rate of unemployment and in part because of rising
expectations of inflation.

A period during which the economy moves down and to the right along a
more-or-less stable short-run Phillips curve as unemployment rises and
inflation falls, during which contractionary economic policies take hold in a
context of relatively stable inflation expectations

A period during which the economy moves down and to the left and
unemployment and inflation both fall as the Phillips curve shifts in, in part
because of a falling natural rate of unemployment and in part because of
falling expectations of inflation.
During the first two of these loops, a rising natural rate coupled with the fact that
inflation expectations rose more as a result of expansionary than they fell as a result of
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contractionary policies meant that the economy drifted toward higher average inflation
and unemployment rates. During the last two of these loops, a falling natural rate coupled
with the fact that inflation expectations rose less as a result of expansionary than they fell
as a result of contractionary policies meant that the economy drifted toward lower
average inflation and unemployment rates. The more-or-less regular decade-after-decade
repetition of this pattern has left many observers expecting it to start again any day now-anticipating that a rise in expected inflation will cause both unemployment and inflation
to start rising again.
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Figure 12.15: Inflation and Unemployment Since 1960
Legend: Since 1960, as the short-run Phillips curve has shifted first outward and
then inward, and as the economy has moved along the short-run Phillips curve,
the
U.S. economy has performed four counter-clockwise loops--some large, some
small--as expansionary policies that push down unemployment raise inflation,
shift expected inflation and so shift the Phillips curve, and then are followed by
contractionary policies to raise unemployment lower inflation, reduce expected
inflation, and shift the Phillips curve back.
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But let us look at what actually happened in more detail
12.6.1 The late 1950s and 1960s: William McChesney Martin
The late 1950s and 1960s saw little change in real interest rates. By and large the Federal
Reserve--chaired by Wiliam McChesney Martin--tried to keep interest rates stable by
following an accomodating monetary policy.
The period 1961-69 saw a boom, as economic policy makers sought to "close the gap"
between the level of total product and potential output through tax cuts and increases in
government spending. They overclosed it. The recovery of investment, the 1964
Kennedy-Johnson tax cut, and the Vietnam War together shifted the IS curve out, raised
real GDP relative to potential output, and lowered the unemployment rate. By the late
1960s it was clear that real GDP was higher than potential output, and inflation was
rising.
Stable prices for most of the 1950s had given the American economy static inflation
expectations when the 1960s opened. Thus for most of the 1960s—as inflation
expectations remained static—the economy moved down and to the right and up and to
the left along a stable short-run Phillips curve. Low inflation was associated with
relatively high unemployment (on the order of 6 percent, well above that period’s natural
rate), and higher inflation (on the order of 4 percent per year) was associated with
relatively low unemployment (below 4 percent).
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Figure 12.16: The U.S. Phillips Curve(s}
The U.S. Phillips Curve(s), 1955-1980
Inflation
10%
1980
9%
1974
8%
Expec ted Inflation
75-80
7%
1976
6%
1970
Natural
Rate, 75-80
5%
Phillips Curve,
1975-1980
1972
4%
1955
3%
1967
2%
Expec ted
Inflation
55-67
1%
1959
1962
Natural
Rate, 55-67
Phillips Curve,
1955-1967
1963
0%
3%
4%
5%
6%
7%
Previous Year's Unemployment
8%
9%
Legend: From the mid-1950s to the late 1960s the U.S. economy moved left and
right along a stable short-run Phillips curve produced by the largely static
expectations of inflation. A prolonged period of low unemployment in the 1960s,
however, caused a shift in expectations from static to adaptive. That shift plus the
supply shocks of the 1970s caused the Phillips curve to shift upward and outward.
By the late 1970s the U.S.'s short-run unemployment-inflation tradeoff was
extremely unfavorable.
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How does inflation accelerate if unemployment stays lower than the “natural” rate for a
long time? We can see the answer in the behavior of unemployment and inflation in the
late 1960s and early 1970s. At the end of the 1960s, U.S. unemployment fell and stayed
below the “natural” rate for eight straight years, from 1966 through 1973. During those
years, inflation accelerated from 1.9% per year in 1965 to 5.6% per year in 1973. Year
after year, unemployment was lower and aggregate demand higher than expected, so
inflation was higher than expected as well. Thus people raised their expectations of
inflation—and the Phillips curve shifted upward.
12.6.2 The 1970s: Arthur Burns
During the 1970s monetary policy in the U.S. was overly expansionary. One reason for
this was Federal Reserve Chair Arthur Burns’s fear that tighter monetary policy to
restrain inflation would generate pressure for Congress to reform or replace the Federal
Reserve. A second reason--perhaps: economists and historians still argue--was President
Nixon’s strong belief that he had put Arthur Burns at the Fed to reassure Nixon’s
election, and that Burns was supposed to do so by generating a loose monetary policy
driven boom in late 1972. A third reason was a general failure to recognize how high
expectations of inflation were, thus how low real interest rates were and how much of a
boost low real interest rates were giving to the economy.
1973 also saw the first of the oil shocks—the first major supply shock. The Organization
of Petroleum Exporting Countries (OPEC) tripled world oil prices. In response,
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investment spending collapsed in 1974-75. The IS curve moved far to the left as
uncertainty led businesses to postpone action until the future became clearer. The sudden
oil-based supply shock pushed the rate of inflation up substantially. And--because
inflation expectations had become adaptive as a result of the variability seen in inflation
in the years surrounding the end of the 1960s--high supply-shock caused inflation in 1974
raised expectations of inflation in 1975 and 1976.
The natural rate of unemployment also rose in the 1970s. The 1970s saw the--then young
and inexperienced--baby-boom generation enter the workforce, which pushed up the
natural rate of unemployment. And the mid-1970s saw a productivity slowdown all
across the industrial world. Because of this productivity slowdown the rates of real wage
increases that everyone had anticipated could not be sustained. And attempts to win what
everyone thought of as standard real wage increases almost surely led to a reduction in
employment, and to a further rise in the natural rate of unemployment.
The effects of these shifts in the natural rate were not well recognized at the time.
Monetary policy became too expansionary because policymakers did not recognize how
high the natural rate had risen, and in the second half of the 1970s inflation accelerated.
By 1979 the Phillips curve had shifted far out and to the right because of the rise in
expected inflation and the rise in the natural rate of unemployment. The rate of inflation
was approaching ten percent per year. A political consensus developed that some steps-even some painful steps--would have to be taken to reduce inflation.
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12.6.3 The 1980s: Paul Volcker
President Carter appointed Paul Volcker Federal Reserve Chair in 1979. Facing nearly
10% inflation per year, Volcker decided that inflation had to be permanently reduced—
and that he was going to tighten monetary policy and send the economy into recession
until it was reduced. When Volcker retired from the Fed in 1987 inflation was only 3%
per year. To reduce inflation, Volcker's Federal Reserve raised interest rates sharply. Real
interest rates rose to previously unseen levels, real GDP fell, and unemployment rose to a
peak near ten percent.
Figure 12.17: The Phillips Curve in the 1980s
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Legend: At the end of the 1970s newly-appointed Federal Reserve Chair Paul
Volcker concluded that reducing inflation and inflation expectations was his
principal task. The Federal Reserve raised interest rates to contract aggregate
demand. High interest rates pushed unemployment up to 10 percent in the early
1980s. The economy moved first down and to the left along an unchanging shortrun Phillips curve and then--as people responded to the change in Federal Reserve
policy by lowering their expectations of inflation--the Phillips curve shifted
downward.
In 1982 came the deepest recession since the Great Depression. But inflation did slow
markedly during the 1980s. First, high unemployment and reduced aggregate demand
moved the economy down and to the right along the early-1980s Phillips curve—pushing
unemployment up to ten percent and inflation down to four percent.
Second, the magnitude of the shift in economic policy under Federal Reserve Chair Paul
Volcker caused investors, managers, and workers to revise their expectations about
inflation. During the mid-1980s the Phillips curve shifted inward: stable inflation was
combined with falling unemployment as investors, managers, and workers realized that
their previous expectations of inflation--geared to the policies of the pre-Volcker 1970s
Federal Reserve--were too high.
Reducing annual inflation by the roughly 6 percentage points accomplished while
Volcker was chairman of the Federal Reserve required substantial "sacrifice": During the
first seven years of Volcker's tenure at the Federal Reserve, unemployment averaged
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some 2 percentage points above the natural rate--and real GDP averaged some 5 percent
below sustainable trend.
12.6.4 The 1990s: Alan Greenspan.
The principal maker of economic policy since the late 1980s has been Federal Reserve
Chair Alan Greenspan--appointed and reappointed by three successive presidents. Federal
Reserve Chair Alan Greenspan also is somewhat of a paradox: a Federal Reserve Chair
whom all trust to be a ferocious inflation fighter, yet one who--in the policies chosen--has
frequently seemed willing to risk higher inflation in order to achieve higher economic
growth, or to avoid a recession.
Greenspan's tenure was marked by a stock market crash in October, 1987. The Alan
Greenspan-led FOMC lowered interest rates and expanded the monetary base, hoping
that this shift in monetary policy would offset any leftward shift in the IS curve
associated with the stock market crash. The stock market crash of 1987 had next to no
effect on investment spending or aggregate demand, and by the end of the 1980s the U.S.
economy had seen inflation begin to rise toward five percent.
In response, the Federal Reserve tightened monetary policy occurred at the same time as
a sudden leftward shift in the IS curve: the Iraqi invasion of Kuwait triggered reduced
investment, as companies waited to see whether the world economy was about to
experience another long-run upward spike in oil prices. The U.S. economy slid into
recession at the end of 1990, and unemployment rose to peak in the middle of 1992.
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Recovery began in 1993, and Greenspan signalled that if Congress and the President took
significant steps to reduce the budget deficit left over from the Reagan and Bush
administrations, the Federal Reserve would maintain lower interest rates--a shift in the
policy mix that would keep the target level of production and employment unchanged,
but that with lower interest rates would promise higher investment and faster productivity
growth: an "investment-led recovery."
Monetary policy turned out extremely well. In 1994, 1995, and 1996 economists talked of
yet another leftward shift in the Phillips curve as investors, managers, and workers had
become more confident in the Federal Reserve’s ability to control inflation and hence
revised their expectations downward even more. By 1997, however, it seemed clear that
something else was going on. 1997 marked the third straight year that unemployment had
been below six percent—a sign in the past that inflation was likely to begin to
accelerate—yet there had been no acceleration of inflation. Economists began to talk first
of special factors. And then, by 1998, economists began to talk of a large reduction in the
natural rate of unemployment—from the 6.5 percent or so of the 1980s down to 5
percent, or perhaps even lower.
Why has the natural rate of unemployment fallen so far? The aging of the labor force in
the 1990s has played a role in reducing the natural rate: older and more experienced
workers are much better at searching for jobs and finding good matches than younger
ones. The fact that a high-investment recovery began to produce more rapid productivity
growth than in the 1970s and 1980s also played a factor. High investment meant
relatively rapid growth in potential output. That meant that firms could offer relatively
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large nominal wage increases without being forced to increase their prices to cover costs.
And those large nominal wage increases thus turned into substantial real wage increases,
at least for skilled workers with substantial labor market bargaining power.
But most of the reduction in the apparent level of the natural rate of unemployment in the
late 1990s remains unexplained: a piece of macroeconomic good luck that few had
anticipated.
Figure 12.18: The U.S. Phillips Curve in the 1990s
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Legend: The 1990s saw yet another inward shift of the Phillips curve, this one in
large part the result of a falling natural rate of unemployment generated by faster
productivity growth.
12.7 From the Short Run to the Long Run
12.7.1 Rational Expectations
Our picture of the determination of real GDP and unemployment under sticky prices is
now complete. We have a comprehensive framework to understand how the aggregate
price level and inflation rate move and adjust over time in response to changes in
aggregate demand, production relative to potential output, and unemployment relative to
its natural rate. There is, however, one loose end. How does one get from the short-run
sticky-price patterns of behavior that have been covered in chapters 9 through 12 to the
long-run flexible price patterns of behavior that were laid out in chapters 6 and 7? How
do you get from the short run to the long run?
In the case of an anticipated shift in economic policy under rational expectations, the
answer is straightforward: you don't have to get from the short run to the long run; the
long run is now. An inward (or outward) shift in the monetary policy reaction function on
the Phillips curve diagram caused by an expansionary (or contractionary) change in
economic policy or the economic environment sets in motion an offsetting shift in the
Phillips curve. In the absence of supply shocks:
   e    (u  u*)
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If expectations are rational and if changes in economic policy are foreseen, then expected
inflation will be equal to actual inflation:
  e
Which means that:
0  (u  u*)
The unemployment rate is equal to the natural rate. The economy is at full employment.
Figure 12.19: The Long Run Is Now…
Legend: Under rational expectations there simply is no short run, unless changes
in
policy come as a complete surprise.
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Because the unemployment rate is equal to the natural rate of unemployment, real GDP is
equal to potential output—and stays equal to potential output no matter what changes
occur in the economic environment and in economic policy, as long as expectations of
inflation are formed rationally and policy changes are anticipated. All the analysis of
chapters 6, 7, and 8 holds.
Box 12.12—Economic Policy: The Slope of the Monetary Policy Reaction Function
and the Effect of Expansionary Policies Under Rational Expectations
We can see how large an increase in inflation is created by a government pursuing
expansionary policies under rational expectations by adding the rational
expectations requirement that actual inflation be equal to expected inflation:
e  
to our Phillips curve and monetary policy reaction function equations:
   e   (u  u*)
u  u0    (  ' )
Expansionary policies are, in this framework, a shift in this last equation.
Expansionary government policies reduce the value of u0, the unemployment rate
when the real interest rate is equal to its normal value r*.
What effect do such policies have? The first equation tells us that under rational
expectations with anticipated policies expected inflation will be equal to actual
inflation. The first and second equations tell us that under rational expectations
with anticipated policies the unemployment rate must be equal to the natural rate:
u u*
Hence the third equation becomes:
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u*  u0    (  ' )
And we can solve this equation for the inflation rate:
u * u0 
  
  ' 
This equation has a very simple and natural interpretation. Take the difference
between the natural rate of unemployment and u0, what the unemployment would
be if the real interest rate were at its normal level r*. This u0 serves as an index of
the extent to which policy is expansionary. Divide this difference by the slope of
the monetary policy reaction function . Add the result to the central bank’s target
inflation rate π’, and you have calculated the rate of inflation. Under rational
expectations, the government’s pursuit of higher production and lower
unemployment has not affected either—unemployment remains equal to the
natural rate, and real GDP remains equal to potential output. But it has raised
inflation.
Moreover, the more cautious the central bank is in fighting inflation—the lower
the parameter —the higher is the resulting inflation rate. In the limit in which the
central bank does not respond to higher inflation by raising real interest rates,
there is no way to solve the equation for the inflation rate π. If the government
tries overly-expansionary policies, and if the central bank is not averse to
inflation, then immediate hyperinflation results.
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Figure: Rational Expectations Plus an Expansionary Shift in Policy Plus a
Vertical Monetary Policy Reaction Function Equals Immediate
Hyperinflation
Inflation
Rate
Aggregate Demand
shifts in...
Inflation explodes
Natural
rate of
unemployment
12.7.2 Adaptive Expectations
Unemployment Rate
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If expectations are and remain adaptive, then the economy approaches the long run
equilibrium laid out in chapters 6 and 7, but in the absence of additional shocks it never
reaches it--although it does converge to it.
An expansionary initial shock that shifts the aggregate demand relation inward on the
Phillips curve diagram generates a fall in unemployment, an increase in real GDP, and a
rise in inflation. Call this stage 1. Stage 1 takes place before anyone has had any chance
to adjust their expectations of inflation.
Then comes stage 2. Workers, managers, investors, and others look at what inflation was
in stage 1 and raise their expectations of inflation. The Phillips curve shifts up by the
difference between actual and expected inflation in stage 1. If the aggregate demand
relation does not shift when plotted on the Phillips curve diagram, between stage 1 and
stage 2 unemployment rises, real GDP falls, and inflation rises.
Then comes stage 3. Workers, managers, investors, and others look at what inflation was
in stage 1 and raise their expectations of inflation. The Phillips curve shifts up by the
difference between actual and expected inflation in stage 2. If the aggregate demand
relation does not shift when plotted on the Phillips curve diagram, between stage 2 and
stage 3 unemployment rises, real GDP falls, and inflation rises. After an arbitrarily large
number of such stages, the gap between actual and expected inflation becomes arbitrarily
small, real GDP become arbitrarily close to potential output, and unemployment becomes
arbitrarily close to its natural rate.
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Figure 12.20: Convergence to the Long Run Under Adaptive Expectations
Legend: Under adaptive expectations, shifts in policy have strong initial effects on
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unemployment and production, but those effects on unemployment and
production
slowly die off over time.
Under adaptive expectations, people's forecasts become closer and closer to being
accurate as more and more time passes. Thus the "long run" arrives gradually. Each year
the portion of the change in demand that is not implicitly incorporated in people's
adaptive forecasts becomes smaller and smaller. Thus a larger and larger proportion of
the shift is "long run" and a smaller and smaller proportion is "short run."
12.7.3 Static Expectations
Under static expectations, the long run never arrives: the analysis of chapters 6 through 8
never becomes relevant. Under static expectations, the gap between expected inflation
and actual inflation can grow arbitrarily large as different shocks affect the economy.
And if the gap between expected inflation and actual inflation becomes large, workers,
managers, investors, and consumers will not remain so foolish as to retain static
expectations.
12.8 Chapter Summary
12.8.1 Main Points
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The location of the Phillips curve is determined by the expected rate of inflation and
the natural rate of unemployment (and possibly by current, active supply shocks). In
the absence of current, active supply shocks, the Phillips curve passes through the
point at which inflation is its expected value and unemployment is its natural rate.
The slope of the Phillips curve is determined by the degree of price stickiness in the
economy. The more sticky are prices, the flatter is the Phillips curve.
The natural rate of unemployment in the U.S. has exhibited moderate swings in the
past two generations: from perhaps 4.5 percent at the end of the 1950s to perhaps 7
percent at the start of the 1980s, and now down to 5 percent or perhaps lower again.
Three significant supply shocks have affected the rate of inflation in the U.S. over the
past two generations: the (inflationary) oil price increases of 1973 and 1979, and the
(deflationary) oil price decrease of 1986.
The principal determinant of the expected rate of inflation is the past behavior of
inflation. If inflation has been low and steady, expectations are probably static, and
the expected inflation rate is very low and unchanging. If inflation has been variable
but moderate, expectations are probably adaptive and expected inflation is probably
simply equal to last year's inflation. If inflation has been high, or moderate but has
varied extremely rapidly, then expectations are probably rational and expected
inflation is likely to be households' and businesses' best guesses of where economic
policy is taking the economy.
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The best way to gauge how expectations of inflation are formed is to consider the past
history of inflation. Would adaptive expectations have provided a significant edge
over static ones? If yes, then inflation expectations are probably adaptive. Would
rational expectations have provided a significant edge over adaptive ones? If yes, then
inflation expectations are probably rational.
The aggregate demand-aggregate supply framework--the IS-LM model and the
Phillips curve--is very useful for understanding macroeconomic events in the U.S.
over the past two generations.
The aggregate demand-aggregate supply framework--the IS-LM model and the
Phillips curve--is not as useful for understanding macroeconomic events in western
Europe over the past two generations. Too much of the variation in unemployment
has been due to changes in the natural rate of unemployment, and not enough to
cyclical variation in unemployment around its natural rate.
Combining the Phillips curve with the Taylor rule monetary policy reaction function
gives us a flexible toolkit to use to analyze inflation and unemployment, and how a
real economy makes the transition from the fixed-price model behavior outlined in
chapters 9 through 11 to the flexible-price model behavior outlined in chapters 6
through 8.
How fast the flexible-price model becomes relevant depends on the type of inflation
expectations in the economy. Under static expectations, the flexible-price model
never becomes relevant. Under adaptive expectations, the flexible-price model
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becomes relevant gradually, in the long run. Under rational expectations the long-run
is now: the flexible-price model analysis is relevant always and immediately.
12.8.2 Important Concepts
Okun’s law
Output gap
Costs of high unemployment
Long and variable lags
Sticky prices
Phillips curve
Natural rate of unemployment
Demography
Labor market institutions
Long-term unemployment
Real wage aspirations
Normal real rate of interest
Normal interest rate level of aggregate demand
Expected inflation
Central bank inflation target
Static expectations
Adaptive expectations
Rational expectations
Natural rate of unemployment
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Sacrifice ratio
Monetary policy reaction function
William McChesney Martin
Arthur Burns
Paul Volcker
Alan Greenspan
12.8.3 Analytical Exercises
1. What is the relationship between the three views of aggregate supply? Why do
economists tend to focus on the Phillips curve to the exclusion of the other two views?
2. Under what circumstances will a government expansionary fiscal or monetary policy
do nothing to raise GDP or lower unemployment?
3. Under the circumstances in which an expansionary government policy fails to raise
GDP or lower unemployment, what would the policy manage to do?
4. If expectations of inflation are adaptive, is there any way to reduce inflation without
suffering unemployment higher than the natural rate? What would you advise a central
bank that sought to reduce inflation without provoking high unemployment to do?
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5. What do you think a central bank should do in response to an adverse supply shock?
How does your answer depend on the way in which expectations of inflation are being
formed in the economy?
6. Suppose that the economy has a Phillips curve:
t   et    (ut ut *)
with the parameter  = 0.5 and the natural rate of unemployment u* equal to 6%. And
suppose that the central bank’s reaction to inflation, the IS curve, and Okun’s law
together mean that the unemployment rate is given by:
ut  u0t    t  t ' 
with the central bank’s target level of inflation π’ equal to 2%, with the parameter  equal
to 0.4, and with the normal real interest rate-level of aggregate demand corresponding to
a value of u0 of 6%. Suppose that initially—this year, in the year zero—that expected
inflation is equal to actual inflation.
a. What is the year-zero level of unemployment?
b. Suppose that the government announces that in year one and in every year thereafter its
expansionary policies will reduce u0 to 4%, that this announcement is credible, and that
the economy has rational expectations of inflation. What will unemployment and
inflation be in year one? What will they be thereafter?
c. Suppose that the government announces that in year one and in every year thereafter its
expansionary policies will reduce u0 to 4%, that this announcement is credible, and that
the economy has adaptive expectations of inflation. What will unemployment and
inflation be in year one? What will they be thereafter?
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d. Suppose that the government announces that in year one and in every year thereafter its
expansionary policies will reduce u0 to 4%, that this announcement is credible, and that
the economy has static expectations of inflation. What will unemployment and inflation
be in year one? What will they be thereafter?
7. Suppose that the economy has a Phillips curve:
t   et    (ut ut *)
with the parameter  = 0.5 and the natural rate of unemployment u* equal to 6%. And
suppose that the central bank’s reaction to inflation, the IS curve, and Okun’s law
together mean that the unemployment rate is given by:
ut  u0t    t  t ' 
with the central bank’s target level of inflation π’ equal to 2%, with the parameter  equal
to 0.4, and with the normal real interest rate-level of aggregate demand corresponding to
a value of u0 of 6%. Suppose that initially—this year, in the year zero—that expected
inflation is equal to actual inflation.
a. What is the year-zero level of unemployment?
b. Suppose that the central bank raises its target inflation rate for next year—year one—to
4%, and announces this change. Suppose the economy has rational expectations of
inflation. What will happen to unemployment and inflation in year one? What will
happen thereafter?
c. Suppose that the central bank raises its target inflation rate for next year—year one—to
4%, and announces this change. Suppose the economy has adaptive expectations of
inflation. What will happen to unemployment and inflation in year one? What will
happen thereafter?
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d. Suppose that the central bank raises its target inflation rate for next year—year one—to
4%, and announces this change. Suppose the economy has static expectations of
inflation. What will happen to unemployment and inflation in year one? What will
happen thereafter?
8. Suppose that the economy has a Phillips curve:
t   et    (ut ut *)
with the parameter  = 0.5 and the natural rate of unemployment u* equal to 6%. And
suppose that the central bank’s reaction to inflation, the IS curve, and Okun’s law
together mean that the unemployment rate is given by:
ut  u0t    t  t ' 
with the central bank’s target level of inflation π’ equal to 2%, with the parameter  equal
to 0.4, and with the normal real interest rate-level of aggregate demand corresponding to
a value of u0 of 6%. Suppose that initially—this year, in the year zero—that expected
inflation is equal to actual inflation.
a. What is the year-zero level of unemployment?
b. Suppose that the natural rate of unemployment u* falls to 4% in year one and remains
at that level indefinitely. And suppose that this fall in the natural rate of unemployment
does not come as a surprise. Suppose the economy has rational expectations of inflation.
What will happen to unemployment and inflation in year one? What will happen
thereafter?
c. Suppose that the natural rate of unemployment u* falls to 4% in year one and remains
at that level indefinitely. And suppose that this fall in the natural rate of unemployment
does not come as a surprise. Suppose the economy has adaptive expectations of inflation.
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What will happen to unemployment and inflation in year one? What will happen
thereafter?
d. Suppose that the natural rate of unemployment u* falls to 4% in year one and remains
at that level indefinitely. And suppose that this fall in the natural rate of unemployment
does not come as a surprise. Suppose the economy has static expectations of inflation.
What will happen to unemployment and inflation in year one? What will happen
thereafter?
12.8.4 Policy-Relevant Exercises [to be updated every year…]
1. Why is the natural rate of unemployment so high in Europe today?
2. Why is the natural rate of unemployment so low in the United States today?
3. Consider the unemployment rate and the inflation rate in the U.S. today and back in
1990. Assume that the slope of the Phillips curve is 1/2--that one percent more
unemployment leads (holding expected inflation) to 1/2 percent less inflation. How much
of the shift in unemployment and inflation in the U.S. since 1990 is due to movements
along the Phillips curve? How much of the shift in unemployment and inflation in the
U.S. since 1990 is due to shifts in the Phillips curve?
4. Consider the unemployment rate and the inflation rate in Britain today and back in
1990. Assume that the slope of the Phillips curve is 1/2--that one percent more
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unemployment leads (holding expected inflation) to 1/2 percent less inflation. How much
of the shift in unemployment and inflation in the France since 1990 is due to movements
along the Phillips curve? How much of the shift in unemployment and inflation in the
France since 1990 is due to shifts in the Phillips curve?
5. Consider the unemployment rate and the inflation rate in France today and back in
1990. Assume that the slope of the Phillips curve is 1/2--that one percent more
unemployment leads (holding expected inflation) to 1/2 percent less inflation. How much
of the shift in unemployment and inflation in France since 1990 is due to movements
along the Phillips curve? How much of the shift in unemployment and inflation in the
France since 1990 is due to shifts in the Phillips curve?
6. Do you think that inflation expectations in the U.S. today are static, adaptive, or
rational? Why?