Trade-off The Between Inflation and Unemployment
The Phillips Curve
The Short-run Curve The Long-run Curve
The Phillips Curve Equation Shifts in the Phillips Curve The Sacrifice Ratio
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The Phillips Curve
Inflation Rate (percent per year) 6
B
2
A Phillips curve 4% 7 Unemployment Rate (percent)
The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and unemployment is low.
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Deriving the Phillips Curve
Suppose P = 100 this year. The following graphs show two possible outcomes for next year:
A. Agg demand low,
small increase in P (i.e., low inflation), low output, high unemployment.
B. Agg demand high,
big increase in P (i.e., high inflation), high output, low unemployment.
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Deriving the Phillips Curve
A. Low agg demand, low inflation, high u-rate
P SRAS 105 10 3 B A AD2 AD1 Y1 Y2 Y 4% 6% 3% 5% B A inflation
PC
u-rate
B. High agg demand, high inflation, low u-rate
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The Phillips Curve: A Policy Menu?
Since fiscal and mon policy affect agg demand, 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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The Phillips Curve in the 1960s
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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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The long-run Phillips curve
Inflation Rate High 1. When the inflation Fed increases the growth rate of the money supply, the rate of inflation Low increases . . . inflation Long-run Phillips curve B 2. . . . but unemployment remains at its natural rate in the long run. A
Unemployment Natural rate of Rate unemployment According to Friedman and Phelps, there is no trade-off between inflation and unemployment in the long run. Growth in the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the longrun Phillips curve is vertical.
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Shifts in Phillips Curve: Role of Expectations
The long-run Phillips curve
Expression of the classical idea of monetary neutrality Increase in money supply
Aggregate-demand curve shifts right
Price level increases Output natural rate
Inflation rate increases
Unemployment natural rate
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4 How the long-run Phillips curve is related to the model of aggregate demand and aggregate supply
(a) The Model of AD and AS Price level Long-run aggregate supply B Inflation Rate (b) The Phillips Curve Long-run Phillips curve
P2
A P1 2. . . . raises the price level . . . 0
1. An increase in the money supply increases aggregate demand . . . AD2
B 3. . . . and increases the inflation rate . . .
A Aggregate demand, AD1 Quantity of output 0
Natural rate of output
4. . . . but leaves output and unemployment at their natural rates.
Natural rate Unemployme Ra of output
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1
The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes faster inflation.
P LRAS inflation high inflation AD2 AD1 Natural rate of output Y low inflation Natural rate of unemployment u-rate
11
LRPC
P2 P1
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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: inflation expected a measure of how much people expect the price level to change.
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The Phillips Curve Equation
Natural rate of unemp.
Unemp. rate
=
Actual Expected a inflation inflation
Short run Fed 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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How Expected Inflation Shifts the PC
Initially, expected & actual inflation = 3%, unemployment = natural rate (6%). Fed makes inflation 2% higher than expected, u-rate falls to 4%. In the long run, expected inflation increases to 5%, PC shifts upward, unemployment returns to its natural rate.
inflation LRPC
5% 3%
B
C A
PC2 PC1
4% 6% u-rate
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A numerical example
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.
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Exercise: Answers
An increase An increase in expected in expected inflation inflation shifts PC to shifts PC to the right. the right. A fall in the A fall in the natural rate natural rate shifts both shifts both curves curves to the left. to the left.
7 6 5 inflation rate 4 3 2 1 0 0 1 2 3 4
LRPCD LRPCA
PCB
PCD PCC
5
6
7
8
16
unemployment rate
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7 The breakdown of the Phillips Curve
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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
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How an Adverse Supply Shock Shifts the PC
SRAS shifts left, prices rise, output & employment fall.
P SRAS2 P2 P1 B A AD Y2 Y1 Y SRAS1 A B inflation
PC2 PC1
u-rate
Inflation & u-rate both increase as the PC shifts upward.
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The 1970s Oil Price Shocks
Oil price per barrel 1/1973 1/1974 1/1979 1/1980 1/1981 $ 3.56 10.11 14.85 32.50 38.00 The Fed chose to accommodate the first shock in 1973 with faster money growth. Result: Higher expected inflation, which further shifted PC. 1979: Oil prices surged again, worsening the Fed's tradeoff.
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The Cost of Reducing Inflation
Disinflation: a reduction in the inflation rate To reduce inflation, Fed must slow the rate of money growth, which reduces agg demand. Short run: Output falls and unemployment rises. Long run: Output & unemployment return to their natural rates.
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Disinflationary Monetary Policy
Contractionary monetary policy moves economy from inflation A to B. Over time, expected inflation falls, PC shifts downward. In the long run, point C: the natural rate of unemployment, lower inflation.
C LRPC A B
PC1 PC2
u-rate natural rate of unemployment
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The Cost of Reducing Inflation
Disinflation requires enduring a period of high unemployment and low output. 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
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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 Early proponents: Robert Lucas, Thomas Sargent, Robert Barro Implied that disinflation could be much less costly...
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