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T H E S O R U N A D E F 9 How an Adverse Supply Shock Shifts the PC u-rate inflation SRAS shifts left, prices rise, output & employment fall. Inflation & u-rate both increase as the PC shifts upward. Y P SRAS 1 AD PC 1 PC 2 A B SRAS 2 A Y 1 P 1 Y 2 B P 2
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T H E S O R U N A D E F 10 The Volcker Disinflation Fed Chairman Paul Volcker Appointed in late 1979 under high inflation & une mployment Changed Fed policy to disinflation 1981-1984: Fiscal policy was expansionary, so Fed policy had to be very contractionary to reduce inflation. Success: Inflation fell from 10% to 4%, but at the cost of high unemployment…
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T H E S O R U N A D E F 11 Disinflationary Monetary Policy Contractionary monetary policy moves economy fr om A to B. Over time, expected inflation falls, PC shifts downward. In the long run, point C: the natural rate of unemployment, lower inflation. u-rate inflation L R P C PC 1 natural rate of unemployment A PC 2 C B
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T H E S O R U N A D E F 12 The Volcker Disinflation Inflation rate (% per year) Unemployment rate (%) 0 2 4 6 8 10 0 2 4 6 8 10 Disinflation turned out to be very costly u-rate near 10% in 1982-83 1979 80 81 82 83 84 85 86 87
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T H E S O R U N A D E F 13
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