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The Short-Run Trade-off between Inflation and Unemployment
1.
Copyright © 2004
South-Western 3535The Short-Run Tradeoff between Inflation and Unemployment
2.
Copyright © 2004
South-Western Unemployment and Inflation • The natural rate of unemployment depends on various features of the labor market. • Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. • The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.
3.
Copyright © 2004
South-Western Unemployment and Inflation • Society faces a short-run tradeoff between unemployment and inflation. • If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. • If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.
4.
Copyright © 2004
South-Western THE PHILLIPS CURVE • The Phillips curve illustrates the short-run relationship between inflation and unemployment.
5.
Figure 1 The
Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B6 7 A 2 Copyright © 2004 South-Western
6.
Copyright © 2004
South-Western Aggregate Demand, Aggregate Supply, and the Phillips Curve • The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.
7.
Copyright © 2004
South-Western Aggregate Demand, Aggregate Supply, and the Phillips Curve • The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. • A higher level of output results in a lower level of unemployment.
8.
Figure 2 How
the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output 0 Short-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level (b) The Phillips Curve Phillips curve Low aggregate demand High aggregate demand (output is 8,000) B 4 6 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7,500 102 A Copyright © 2004 South-Western
9.
Copyright © 2004
South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS • The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.
10.
Copyright © 2004
South-Western The Long-Run Phillips Curve • In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. • As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. • Monetary policy could be effective in the short run but not in the long run.
11.
Figure 3 The
Long-Run Phillips Curve Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve BHigh inflation Low inflation A 2. . . . but unemployment remains at its natural rate in the long run. 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . . Copyright © 2004 South-Western
12.
Figure 4 How
the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level P Aggregate demand, AD Long-run aggregate supply Long-run Phillips curve (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve 2. . . . raises the price level . . . 1. An increase in the money supply increases aggregate demand . . . A AD2 B A 4. . . . but leaves output and unemployment at their natural rates. 3. . . . and increases the inflation rate . . . P2 B Copyright © 2004 South-Western
13.
Copyright © 2004
South-Western Expectations and the Short-Run Phillips Curve • Expected inflation measures how much people expect the overall price level to change.
14.
Copyright © 2004
South-Western Expectations and the Short-Run Phillips Curve • In the long run, expected inflation adjusts to changes in actual inflation. • The Fed’s ability to create unexpected inflation exists only in the short run. • Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.
15.
Copyright © 2004
South-Western • This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation. Expectations and the Short-Run Phillips Curve ( )N a t u r a l r a t e o f u n e m p l o y m e n t - a A c t u a l i n f l a t i o n E x p e c t e d i n f l a t i o n− Unemployment Rate =
16.
Figure 5 How
Expected Inflation Shifts the Short- Run Phillips Curve Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short-run Phillips curve . . . 2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B A Copyright © 2004 South-Western
17.
Copyright © 2004
South-Western The Natural Experiment for the Natural-Rate Hypothesis • The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. • Historical observations support the natural-rate hypothesis.
18.
Copyright © 2004
South-Western The Natural Experiment for the Natural Rate Hypothesis • The concept of a stable Phillips curve broke down in the in the early ’70s. • During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.
19.
Figure 6 The
Phillips Curve in the 1960s 1 2 3 4 5 6 7 8 9 100 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) 1968 1966 1961 1962 1963 1967 1965 1964 Copyright © 2004 South-Western
20.
Figure 7 The
Breakdown of the Phillips Curve 1 2 3 4 5 6 7 8 9 100 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) 1973 1966 1972 1971 1961 1962 1963 1967 1968 1969 1970 1965 1964 Copyright © 2004 South-Western
21.
Copyright © 2004
South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • Historical events have shown that the short-run Phillips curve can shift due to changes in expectations.
22.
Copyright © 2004
South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • The short-run Phillips curve also shifts because of shocks to aggregate supply. • Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. • An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.
23.
Copyright © 2004
South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. • This shifts the economy’s aggregate supply curve. . . • . . . and as a result, the Phillips curve.
24.
Figure 8 An
Adverse Shock to Aggregate Supply Quantity of Output 0 Price Level Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve 3. . . . and raises the price level . . . AS2 Aggregate supply, AS A 1. An adverse shift in aggregate supply . . . 4. . . . giving policymakers a less favorable tradeoff between unemployment and inflation. BP2 Y2 P A Y Phillips curve,PC 2. . . . lowers output . . . PC2 B Copyright © 2004 South-Western
25.
Copyright © 2004
South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. • Fight the unemployment battle by expanding aggregate demand and accelerate inflation. • Fight inflation by contracting aggregate demand and endure even higher unemployment.
26.
Figure 9 The
Supply Shocks of the 1970s 1 2 3 4 5 6 7 8 9 100 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) 1972 19751981 1976 1978 1979 1980 1973 1974 1977 Copyright © 2004 South-Western
27.
Copyright © 2004
South-Western THE COST OF REDUCING INFLATION • To reduce inflation, the Fed has to pursue contractionary monetary policypolicy. • When the Fed slows the rate of money growth, it contracts aggregate demand. • This reduces the quantity of goods and services that firms produce. • This leads to a rise in unemployment.
28.
Figure 10 Disinflationary
Monetary Policy in the Short Run and the Long Run Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve . . . 2. . . . but in the long run, expected inflation falls, and the short-run Phillips curve shifts to the left. BC A Copyright © 2004 South-Western
29.
Copyright © 2004
South-Western THE COST OF REDUCING INFLATION • To reduce inflation, an economy must endure a period of high unemployment and low output. • When the Fed combats inflation, the economy moves down the short-run Phillips curve. • The economy experiences lower inflation but at the cost of higher unemployment.
30.
Copyright © 2004
South-Western THE COST OF REDUCING INFLATION • The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. • An estimate of the sacrifice ratio is five. • To reduce inflation from about 10% in 1979-1981 to 4% would have required an estimated sacrifice of 30% of annual output!
31.
Copyright © 2004
South-Western Rational Expectations and the Possibility of Costless Disinflation • The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.
32.
Copyright © 2004
South-Western Rational Expectations and the Possibility of Costless Disinflation • Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run. • How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.
33.
Copyright © 2004
South-Western Rational Expectations and the Possibility of Costless Disinflation • The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.
34.
Copyright © 2004
South-Western The Volcker Disinflation • When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the nation’s foremost problems. • Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).
35.
Figure 11 The
Volcker Disinflation 1 2 3 4 5 6 7 8 9 100 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) 1980 1981 1982 1984 1986 1985 1979 A 1983 B 1987 C Copyright © 2004 South-Western
36.
Copyright © 2004
South-Western The Greenspan Era • Alan Greenspan’s term as Fed chairman began with a favorable supply shock. • In 1986, OPEC members abandoned their agreement to restrict supply. • This led to falling inflation and falling unemployment.
37.
Figure 12 The
Greenspan Era 1 2 3 4 5 6 7 8 9 100 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) 1984 1991 1985 1992 1986 1993 1994 1988 1987 1995 1996 20021998 1999 2000 2001 1989 1990 1997 Copyright © 2004 South-Western
38.
Copyright © 2004
South-Western The Greenspan Era • Fluctuations in inflation and unemployment in recent years have been relatively small due to the Fed’s actions.
39.
Copyright © 2004
South-Western Summary • The Phillips curve describes a negative relationship between inflation and unemployment. • By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. • By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.
40.
Copyright © 2004
South-Western Summary • The tradeoff between inflation and unemployment described by the Phillips curve holds only in the short run. • The long-run Phillips curve is vertical at the natural rate of unemployment.
41.
Copyright © 2004
South-Western Summary • The short-run Phillips curve also shifts because of shocks to aggregate supply. • An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.
42.
Copyright © 2004
South-Western Summary • When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve. • This results in temporarily high unemployment. • The cost of disinflation depends on how quickly expectations of inflation fall.
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