Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

Nguyen Thi Thuy VINH

The Short-Run Tradeoff

between Inflation and
Unemployment

1
Chapter 35-The Short-Run Tradeoff between Inflation and Unemployment

• In the long run, inflation & unemployment are

unrelated:
- The inflation rate depends mainly on growth in the
money supply
- Unemployment (the “natural rate”) depends on the
minimum wage, the market power of unions,
efficiency wages, and the process of job search.
• In the short run: one of the Ten Principles
In the short run, society faces a trade-off
between inflation and unemployment.

I- The Phillips Curve

• Phillips curve: shows the short-run trade-off

between inflation and unemployment
• 1958: A.W. Phillips showed that nominal wage
growth was negatively correlated with unemployment
in the U.K.
• 1960: Paul Samuelson & Robert Solow found a
negative correlation between U.S. inflation &
unemployment, named it “the Phillips Curve.”

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

1. Deriving the Phillips Curve in Short Run

• Suppose P = 100 this year.

• The following graphs show two possible outcomes
for next year:
A. AD low, small increase in P (i.e., low inflation),
low output, high unemployment.
B. AD high, big increase in P (i.e., high inflation),
high output, low unemployment.

Deriving the Phillips Curve

A. Low AD, low inflation, high u-rate
P inflation

SRAS
B B
5%
105
A
103 3% A
AD2
PC
AD1

Y1 Y2 Y 4% 6% u-rate

B. High AD, high inflation, low u-rate

 The Phillips Curve: A Policy Menu?

• Since fiscal and monetary policy affect AD,

the PC appeared to offer policymakers a menu
of choices:
– low unemployment with high inflation
– low inflation with high unemployment
– anything in between
• 1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

Evidence for the Phillips Curve?

Inflation rate
(% per year) During the 1960s,
U.S. policymakers
10
opted for reducing
8 unemployment
at the expense of
6 higher inflation

4 68
66
67
2 62
65
1961
64 63
0
0 2 4 6 8 10 Unemployment
rate (%)

Phillips Curve in US during the Financial Crisis

2. The Vertical Long-Run Phillips Curve

• 1968: Milton Friedman and Edmund Phelps argued

that the tradeoff was temporary.
• Natural-rate hypothesis: the claim that
unemployment eventually returns to its normal or
“natural” rate, regardless of the inflation rate
• Based on the classical dichotomy and the vertical
LRAS curve

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

The Vertical Long-Run Phillips Curve

In the long run, faster money growth only causes faster
inflation.
P inflation
LRAS LRPC

high
P2 infla-
tion
P1 AD2 low
infla-
AD1 tion
Y u-rate
Natural rate Natural rate of
of output unemployment
10

3. The Phillips Curve Equation

 Reconciling Theory and Evidence

• Evidence (from ’60s):

PC slopes downward.
• Theory (Friedman and Phelps):
PC is vertical in the long run.
• To bridge the gap between theory and evidence,
Friedman and Phelps introduced a new variable:
expected inflation – a measure of how much people
expect the price level to change.

3. The Phillips Curve Equation

Natural
Unemp.
= rate of – a Actual – Expected
rate inflation inflation
unemp.

Short run
CB can reduce u-rate below the natural u-rate
by making inflation greater than expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate whether inflation is
high or low.

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

 How Expected Inflation Shifts the PC

Initially, expected &
actual inflation = 3%,
inflation
unemployment = LRPC
natural rate (6%).
CB makes inflation
2% higher than expected, B C
5%
u-rate falls to 4%.
3% A
In the long run,
expected inflation increases PC2
to 5%, PC shifts upward, PC1
unemployment returns to its
4% 6% u-rate
natural rate.

NOW YOU TRY:

Phillips Curve
Natural rate of unemployment = 5%
Expected inflation = 2%
In PC equation, a = 0.5
A. Plot the long-run Phillips curve.
B. Find the u-rate for each of these values of actual
inflation: 0%, 6%. Sketch the short-run PC.
C. Suppose expected inflation rises to 4%.
Repeat part B.
D. Instead, suppose the natural rate falls to 4%. Draw
the new long-run Phillips curve,
then repeat part B.

NOW YOU TRY:

Answers LRPCD
PCB LRPCA
7
An increase
in expected 6
inflation
5
inflation rate

shifts PC to
the right. 4
PCD
3

A fall in the PCC

2
natural rate
1
shifts both
curves 0
to the left. 0 1 2 3 4 5 6 7 8
unemployment rate

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

The Breakdown of the Phillips Curve

Inflation rate
(% per year) Early 1970s:
unemployment increased,
10
despite higher inflation.
8 Friedman &
Phelps’
6 73
69 71 explanation:
70
4 68
72
expectations
66 were catching
67
2 62 up with reality.
65
1961
64 63
0
0 2 4 6 8 10 Unemployment
rate (%)

 Another PC Shifter: Supply Shocks

• Supply shock:
an event that directly alters firms’ costs and prices,
shifting the AS and PC curves
• Example: large increase in oil prices

How an Adverse Supply Shock Shifts the PC

SRAS shifts left, prices rise, output & employment fall.
P inflation
SRAS2
SRAS1
B B
P2

P1 A A
PC2

AD PC1
Y2 Y1 Y u-rate

Inflation & u-rate both increase as the PC shifts upward.

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

The 1970s Oil Price Shocks

Oil price per barrel The Fed chose to accommodate
1/1973 $ 3.56 the first shock in 1973
with faster money growth.
1/1974 10.11
Result:
1/1979 14.85 Higher expected inflation, which
1/1980 32.50 further shifted PC.
1/1981 38.00 1979:
Oil prices surged again,
worsening the Fed’s tradeoff.

The 1970s Oil Price Shocks

Inflation rate
(% per year) Supply
shocks &
10 81 75
rising
74
80 expected
8 79
78 inflation
6 77 worsened
73
76 the PC
4 1972 tradeoff.

0
0 2 4 6 8 10 Unemployment
rate (%)

II. The Cost of Reducing Inflation

1. Disinflation:
• a reduction in the inflation rate
• To reduce inflation,
Central bank must slow the rate of money growth,
which reduces AD.
• Short run:
Output falls and unemployment rises.
• Long run:
Output & unemployment return to their natural rates.

11-The Short-Run Tradeoff between Inflation and Unemployment

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

Disinflationary Monetary Policy

Contractionary monetary
policy moves economy inflation
from A to B. LRPC
Over time,
expected inflation falls, A
PC shifts downward.
B
In the long run, C
point C: PC1
the natural rate PC2
of unemployment,
lower inflation. u-rate
natural rate of
unemployment

II. The Cost of Reducing Inflation

2. Sacrifice ratio
percentage points of annual output lost
per 1 percentage point reduction in inflation
• Typical estimate of the sacrifice ratio: 5
– To reduce inflation rate 1%,
must sacrifice 5% of a year’s output.
• Can spread cost over time, e.g.
To reduce inflation by 6%, can either
– sacrifice 30% of GDP for one year
– sacrifice 10% of GDP for three years

II. The Cost of Reducing Inflation

3. Rational Expectations, Costless Disinflation?

• Rational expectations: a theory according to which

people optimally use all the information they have,
including info about govt policies, when forecasting
the future
• Implied that disinflation could be much less costly…

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Chapter 35 The Short-Run Tradeoff between Inflation and Unemployment

II. The Cost of Reducing Inflation

3. Rational Expectations, Costless Disinflation?

• Suppose the central bank convinces everyone it is

committed to reducing inflation.
• Then, expected inflation falls,
the short-run PC shifts downward.
• Result:
Disinflations can cause less unemployment
than the traditional sacrifice ratio predicts.

CONCLUSION

• The theories in this chapter come from some of

the greatest economists of the 20th century.
• They teach us that inflation and unemployment
are
– unrelated in the long run
– negatively related in the short run
– affected by expectations,
which play an important role in the economy’s
adjustment from the short-run to the long run.