Download 12 - Brad DeLong

12.5 Understanding Fluctuations in Unemployment and
Inflation
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, we see that the economy as
plotted 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 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-or-less
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-orless 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
contractionary policies meant that the economy drifted toward higher average inflation
and unemployment rates.
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.
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.
Figure 12.17: The Phillips Curve in the 1980s
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.
The 1960s and 1970s
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. By the late 1960s it was clear that real
GDP was higher than potential output, and inflation was rising. Inflation accelerated from
1.9% per year in 1965 to 5.6% per year in 1973.
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.
But the most important reason for rising inflation in the 1970s is the first major supply
shock. The Organization of Petroleum Exporting Countries (OPEC) tripled world oil
prices. 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 1980s and 1990s
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. 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.
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 began with 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. 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.
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.
Figure 12.18: The U.S. Phillips Curve in the 1990s
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.