Chapter 35:
The Short-Run Trade-off between Inflation and
Unemployment
1. The Phillips Curve:
1.1. Origins of the Phillips Curve:
- Phillips curve: a curve that shows the short-run trade-off between inflation and
unemployment
- It illustrates a negative association between the inflation rate and the unemployment
rate.
● Low unemployment => high inflation
● High unemployment => low inflation
- Since fiscal and monetary 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.
1.2. Aggregate Demand, Aggregate Supply, and the Phillips Curve:
- The Phillips curve shows the combinations of inflation and unemployment that arise
in the short run as shifts in the aggregate-demand curve move the economy along the
short-run aggregate-supply curve
- Natural-rate hypothesis: the claim that unemployment eventually returns to its
normal or “natural” rate in the long-run, regardless of the inflation rate
- The greater the expansion of the money supply, the faster AD will shift to the right,
resulting in a larger increase in prices
But this higher inflation will not produce lower unemployment in the long run,
unemployment always goes to its natural rate whether inflation is high or low.
In the long run, faster money growth only causes faster inflation.
2. Shifts in the Phillips Curve: the role of expectations
- Long-Run Phillips Curve: vertical, price level and inflation do not affect unemployment rate
in the long run (follow classical theory)
● Unemployment rate does not depend on money growth or inflation
❖ Reconciling Theory and Evidence:
- Theory (Friedman and Phelps): PC is vertical in the long run.
- A variable of the analysis of the inflation–unemployment trade-off: expected
inflation: expected inflation - a measure of how much people expect the price
level to change.
+ Expected price level affects nominal wages
+ Determines the position of the short-run aggregate-supply curve.
- The Phillips Curve Equation:
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 = 𝑛𝑎𝑡𝑢𝑟𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 − 𝑎 × (𝑎𝑐𝑡𝑢𝑎𝑙
𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛)
- Short run: Fed can reduce u-rate below the natural u-rate by making inflation
greater than expected.
+ There can be no stable short-run Phillips curve.
+ Each short-run Phillips curve reflects a particular expected rate of inflation.
+ Expected inflation increases → the short-run Phillips curve shifts rightward and vice
versa.
- Long run: Expectations catch up to reality, u-rate goes back to natural u-rate
whether inflation is high or low.
- Natural rate of unemployment is not necessarily socially desirable, not constant.
- The vertical long-run aggregate-supply curve and the vertical long-run Phillips
curve both imply that monetary policy influences nominal variables (the price level
and the inflation rate) not real variables (output and unemployment).
How Expected Inflation Shifts the Short-Run Phillips Curve
Example:
- Initially,
+ expected & actual inflation = 3%,
+ Natural unemployment 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.
- Monetary policy does not affect natural rate of unemployment.
- Expansionary policy moves the economy up along the short-run Phillips curve,
expected inflation rises → short-run Phillips curve shifts right and vice versa.
❖ The Natural Experiment for the Natural-Rate Hypothesis
- Natural-rate hypothesis: unemployment eventually returns to its normal, or
natural, rate, regardless of the rate of inflation
3. Shifts in the Phillips Curve: The Role of Supply Shocks:
- Supply shock: an event that directly alters firms’ costs and prices, shifting the
economy’s aggregate supply curve and thus the Phillips curve
+ Short-run aggregate supply shifts left.
+ Short-run Phillips curve shifts right.
Example: large increase in oil prices → raises the cost of producing gasoline →
reduces the quantity of goods and services supplied.
As panel (a) shows, this reduction in supply is represented by the leftward shift in
the aggregate-supply curve from AS1 to AS2. Output falls from Y1 to Y2, and
the price level rises from P1 to P2. A combination of lower output and higher
price level results in a rightward shift in Short-run Phillips curve.
- Stagflation: The combination of falling output (stagnation) and rising prices
(inflation)
An Adverse Shock to Aggregate Supply
4. The Cost of Reducing Inflation:
Disinflation: a reduction in the rate of inflation. Disinflation is different from Deflation
(a reduction in the price level). Disinflation is like slowing down, whereas Deflation is
like going in reverse.
❖ The Sacrifice Ratio:
- To reduce inflation, Fed must slow the rate of money growth, which reduces
aggregate demand.
+ Short run: Output falls and unemployment rises.
+ Long run: Output & unemployment return to their natural rates.
- Contractionary monetary policy moves economy from A to B.
- Over time, expected inflation falls, Phillips Curve shifts downward.
- In the long run, at point C: unemployment is back at its natural rate, but with
lower inflation.
Disinflation requires enduring a period of high unemployment and low output.
- Sacrifice Ratio: the number of percentage points of annual output lost in the
process of reducing inflation by 1 percentage point.
For example: Typical estimate of the sacrifice ratio: 5. Which means: to reduce
inflation rate 1%, must sacrifice 5% of a year’s output.
- Sacrifice can be spread out over time.
For example: To reduce inflation by 6%, can either
+ sacrifice 30% of GDP for one year
+ sacrifice 10% of GDP for three years
Rational Expectations and the Possibility of Costless Disinflation:
- Rational Expectation: the theory that people optimally use all the information
they have, including information about government policies, when forecasting
the future.
- Government is Credible: people adjust expected inflation quickly,
unemployment rate gets back to its natural rate quicklier and vice versa.
- Low sacrifice ratio: shorter labor contracts, Central Bank is credible and vice
versa.
For example: Suppose the Fed successfully convinces everyone it is committed to
reducing inflation. Then expected inflation falls, the short-run Phillips Curve shifts
downward quicklier.
Result: Disinflations can cause less unemployment than the traditional sacrifice ratio
predicts when people find the government credible.
