ENQUIRING INTO LOW INFLATION &LOW

UNEMPLOYMENT DILEMMA

As the 20th century drew to a close, the US economy was

experiencing some of the lowest rates of inflation and
unemployment in many years. In 1999, for instance,
unemployment had fallen to 4.2 percent, while inflation was
running at a mere 1.3 percent per year. As measured by these two
important macroeconomic variables, the US was enjoying a period
of unusual prosperity.

Some observers argued that this experience cast doubt on the

theory of the Phillips curve. Indeed, the combination of low
inflation and low unemployment might seen to suggest that there
was no longer a trade-off between these two variables.

Yet most economists took a less radical view of events. In the

1990s, this trade-off shifted leftward, allowing the economy to
enjoy low unemployment and low inflation simultaneously.

What caused this favourable shift in the short-run Phillips curve?

Part of the answer lies in a fall in expected inflation. Under Paul
Volcker and Alan Greenspan, the Fed pursued a policy aimed at
reducing inflation and keeping it low. Over time, as this policy
succeeded, the Fed gained credibility with the public that it would
continue to fight inflation as necessary. The increased credibility
lowered inflation expectations, which shifted the short-run Phillips
curve to the left.

In addition to this, shift from reduced expected inflation, many

economists believe that the US economy experienced some
favourable supply shocks during this period. A favourable supply
shocks shifts the short-run aggregate supply curve to the right,
raising output and reducing prices. It therefore reduces both
unemployment and inflation and shifts the short-run Phillips
curveto the left.

Technical Reasoning

Importance of Three core events :

I. Declining Commodity Prices:

In the late 1990s, the prices of many basic commodities,
including oil, fell on world markets. This fall in commodity
prices, in turn, was partly due to a deep recession in Japan
and other Asian economies, which reduced the demand for
these products.

II. Labour-Market Changes:

Some economists believe that the aging of the large baby-

boom generation born after World War II has caused
fundamental changes in the labour market. Because older
workers are typically in more stable jobs than younger
workers.

III. Technological Advance:

In the second half of the 1990s, the US economy entered a

period of rapid technological progress. Advances in
information technology, such as the Internet, have been
profound and have influenced many parts of the economy.
Critical Analysis:

I. Because commodities are an important input into

production, the fall in their prices reduced producers’
costs and acted as a favourable supply shock for the
U.S. economy.
II. An increase in the average age of the labour force
reduces the economy’s natural rate of unemployment.
III. Such technological advance increases productivity and
therefore, is a type of favourable supply shock.
1. The labor force consists of the number of employed (142,076,000) plus the
number of unemployed (7,497,000), which equals 149,573,000.

To find the labor-force participation rate, we need to know the size of the adult
population. Adding the labor force (149,573,000) to the number of people not in
the labor force (76,580,000) gives the adult population of 226,153,000. The labor-
force participation rate is the labor force (149,573,000) divided by the adult
population (226,153,000) times 100%, which equals 66%.

The unemployment rate is the number of unemployed (7,497,000) divided by the

labor force (149,573,000) times 100%, which equals 5.0%.

2. Many answers are possible.

3. Men age 55 and over experienced the greatest decline in labor-force participation.
This was because of increased Social Security benefits and retirement income,
encouraging retirement at an earlier age.

4. Younger women experienced a bigger increase in labor-force participation than

older women because more of them have entered the labor force (in part because
of social changes), so there are more two-career families. In addition, women
have delayed having children until later in life and have reduced the number of
children they have, so they are in the labor force for a greater proportion of their
lives than was the case previously.

5. The fact that employment increased 1.5 million while unemployment declined 0.6
million is consistent with growth in the labor force of 0.9 million workers. The
labor force constantly increases as the population grows and as labor-force
participation increases, so the increase in the number of people employed may
always exceed the reduction in the number unemployed.

6. a. A construction worker who is laid off because of bad weather is likely to

experience short-term unemployment, because the worker will be back to
work as soon as the weather clears up.

b. A manufacturing worker who loses her job at a plant in an isolated area is

likely to experience long-term unemployment, because there are probably
few other employment opportunities in the area. She may need to move
somewhere else to find a suitable job, which means she will be out of
work for some time.

c. A worker in the stagecoach industry who was laid off because of the
growth of railroads is likely to be unemployed for a long time. The worker
will have a lot of trouble finding another job because his entire industry is
shrinking. He will probably need to gain additional training or skills to get
a job in a different industry.
 d. A short-order cook who loses his job when a new restaurant opens is
likely to find another job fairly quickly, perhaps even at the new
restaurant, and thus will probably have only a short spell of
unemployment.

e. An expert welder with little education who loses her job when the
company installs automatic welding machinery is likely to be without a
job for a long time, because she lacks the technological skills to keep up
with the latest equipment. To remain in the welding industry, she may
need to go back to school and learn the newest techniques.

Figure 13
3. a. Figure 13 shows how a reduction in consumer spending causes a recession
in both an aggregate-supply/aggregate-demand diagram and a Phillips-
curve diagram. In both diagrams, the economy begins at full employment
at point A. The decline in consumer spending reduces aggregate demand,
shifting the aggregate-demand curve to the left from AD1 to AD2. The
economy initially remains on the short-run aggregate-supply curve SRAS1,
so the new equilibrium occurs at point B. The movement of the aggregate-
demand curve along the short-run aggregate-supply curve leads to a
movement along short-run Phillips curve SRPC1, from point A to point B.
The lower price level in the aggregate-supply/aggregate-demand diagram
corresponds to the lower inflation rate in the Phillips-curve diagram. The
lower level of output in the aggregate-supply/aggregate-demand diagram
corresponds to the higher unemployment rate in the Phillips-curve
diagram.
 b. As expected inflation falls over time, the short-run aggregate-supply curve
shifts down from AS1 to AS2, and the short-run Phillips curve shifts down
from SRPC1 to SRPC2. In both diagrams, the economy eventually gets to
point C, which is back on the long-run aggregate-supply curve and long-
run Phillips curve. After the recession is over, the economy faces a better
set of inflation-unemployment combinations.

1. Figure 8 shows two different short-run Phillips curves depicting these four points.
Points A and D are on SRPC1 because both have expected inflation of 3%. Points
B and C are on SRPC2 because both have expected inflation of 5%.

To see how policy can move the economy from a point with high inflation to a point with
low inflation, suppose the economy begins at point A in Figure 2. If policy is
used to reduce aggregate demand (such as a decrease in the money supply or a
decrease in government purchases), the aggregate-demand curve shifts from AD1
to AD2, and the economy moves from point A to point B with lower inflation, a
reduction in real GDP, and an increase in the unemployment rate.
Figure 2

2. Figure 3 shows the short-run Phillips curve and the long-run Phillips curve. The
curves are different because in the long run, monetary policy has no effect on
unemployment, which tends toward its natural rate. However, in the short run,
monetary policy can affect the unemployment rate. An increase in the growth rate
of money raises actual inflation above expected inflation, causing firms to
produce more since the short-run aggregate supply curve is positively sloped,
which reduces unemployment temporarily.

Figure 3

3. Examples of favorable shocks to aggregate supply include improved productivity

and a decline in oil prices. Either shock shifts the aggregate-supply curve to the
right, increasing output and reducing the price level, moving the economy from
point A to point B in Figure 4. As a result, the Phillips curve shifts to the left, as
the figure shows.
Figure 4

4. The sacrifice ratio is the number of percentage points of annual output lost in the
process of reducing inflation by 1 percentage point. The credibility of the Fed’s
commitment to reduce inflation might affect the sacrifice ratio because it affects
the speed at which expectations of inflation adjust. If the Fed’s commitment to
reduce inflation is credible, people will reduce their expectations of inflation
quickly, the short-run Phillips curve will shift downward, and the cost of reducing
inflation will be low in terms of lost output. But if the Fed is not credible, people
will not reduce their expectations of inflation quickly, and the cost of reducing
inflation will be high in terms of lost output.