1. © 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R The Short-Run Trade-off Between Inflation and Unemployment M acroeconomics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 22

2. In this chapter, look for the answers to these questions:  How are inflation and unemployment related in the short run? In the long run?  What factors alter this relationship?  What is the short-run cost of reducing inflation?  Why were U.S. inflation and unemployment both so low in the 1990s? 1

3. THE SHORT-RUN TRADE-OFF 2 Introduction  In the long run, inflation & unemployment are unrelated:  The inflation rate depends mainly on growth in the money supply.  Unemployment (the “natural rate”) depends on the minimum wage, the market power of unions, efficiency wages, and the process of job search.  Uh, how about this order: The process of job search, efficiency wages, the market power of unions and the minimum wage?

4. THE SHORT-RUN TRADE-OFF 3 Introduction  One of the Ten Principles: In the short run, society faces a trade-off between inflation and unemployment.

5. THE SHORT-RUN TRADE-OFF 4 The Phillips Curve  Phillips curve: shows the short-run trade-off between inflation and unemployment  1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in the U.K.  1960: Paul Samuelson & Robert Solow found a negative correlation between U.S. inflation & unemployment, named it “the Phillips Curve.”

6. THE SHORT-RUN TRADE-OFF 5 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.

7. THE SHORT-RUN TRADE-OFF 6 Deriving the Phillips Curve u-rate inflation PC A. Low agg demand, low inflation, high u-rate B. High agg demand, high inflation, low u-rate Y P SRAS AD 1 AD 2 Y1Y1 103 A 105 Y2Y2 B 6% 3% A 4% 5% B

8. Digression: What does a lecture cost?  A&S in-state tuition: $1,276 for 4-credit course with 30 lectures - $42.53 per lecture.  Business School in-state tuition: $2,040 for 4- credit course with 30 lectures - $68.00 per lecture.  A&S out-of-state tuition: $14,000. Assuming 15 credits, $3,733 for 4-credit course with 30 lectures - $124.44 per lecture. THE SHORT-RUN TRADE-OFF 7

9. Digression: Structure of the final 1  150 minutes  We provide answer sheets  We provide questions  You provide your brain and your #2 pencils (bring several)  Do not bring notes, calculators, computers, cell phones, pagers, hats with brims (seriously) or anything else which might even hint at the possibility of containing information which might be inappropriately useful. THE SHORT-RUN TRADE-OFF 8

10. Digression: Structure of the final 2  120 questions:  60 1 minute questions, 30 of difficulty level 1 and 30 of difficulty level 2  60 1.5 minute questions of difficulty level 3  39 points on Chapters 3-14  110 points on Chapters 15-23  In order of the chapters Do not ignore the questions on the earlier chapters! But move through them promptly in order to get to the many points on later chapters THE SHORT-RUN TRADE-OFF 9

11. Sneak clicker question  The Fed is about to end its program of “quantitative easing”. For our purposes, this means that it is going to stop expanding the money supply. The consequence will be  A. Shift the supply curve for money in and drive the interest rate up.  B. Shift the supply curve for money in and drive the interest rate down.  C. Shift the supply curve for money out and drive the interest rate up.  D. Shift the supply curve for money out and drive the interest rate down. THE SHORT-RUN TRADE-OFF 10

12. Sneak clicker question 2  The Fed is about to end its program of “quantitative easing”. For our purposes, this means that it is going to stop expanding the money supply. The consequence will be  A. Shift the supply curve for money in and shift the AD curve in.  B. Shift the supply curve for money in and shift the AD curve out.  C. Shift the supply curve for money out and shift the AD curve in.  D. Shift the supply curve for money out and shift the AD curve out. THE SHORT-RUN TRADE-OFF 11

13. Sneak clicker question 3  In the short run, the end of “quantitative easing” will result in  A. Higher Y and higher P  B. Higher Y and lower P  C. Lower Y and higher P  D. Lower Y and lower P THE SHORT-RUN TRADE-OFF 12

14. Sneak clicker question 4  In the long run, the end of “quantitative easing” will result in  A. Full-employment Y and higher P  B. Full-employment Y and lower P  C. Lower Y and higher P  D. Lower Y and lower P THE SHORT-RUN TRADE-OFF 13

15. THE SHORT-RUN TRADE-OFF 14 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.

16. THE SHORT-RUN TRADE-OFF 15 Evidence for the Phillips Curve? Inflation rate (% per year) Unemployment rate (%) During the 1960s, U.S. policymakers opted for reducing unemployment at the expense of higher inflation 1961 63 65 62 64 66 67 68

17. THE SHORT-RUN TRADE-OFF 16 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

18. The Vertical Long-Run Phillips Curve u-rate inflation In the long run, faster money growth only causes faster inflation. Y P LRAS AD 1 AD 2 Natural rate of output Natural rate of unemployment P1P1 P2P2 LRPC low infla- tion high infla- tion 17

19. THE SHORT-RUN TRADE-OFF 18 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: expected inflation – a measure of how much people expect the price level to change.

20. THE SHORT-RUN TRADE-OFF 19 The Phillips Curve Equation 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. Unemp. rate Natural rate of unemp. = – a Actual inflation Expected inflation –

21. THE SHORT-RUN TRADE-OFF 20 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. u-rate inflation PC 1 LRPC 6% 3% PC 2 4% 5% A B C

22. 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. A C T I V E L E A R N I N G 1 A numerical example 21

23. A C T I V E L E A R N I N G 1 Answers 22 LRPC A An increase in expected inflation shifts PC to the right. PC D LRPC D PC B PC C A fall in the natural rate shifts both curves to the left.

24. THE SHORT-RUN TRADE-OFF 23 The Breakdown of the Phillips Curve Inflation rate (% per year) Unemployment rate (%) Early 1970s: unemployment increased, despite higher inflation. Friedman & Phelps’ explanation: expectations were catching up with reality. 1961 63 65 62 64 66 67 68 69 70 71 72 73

25. THE SHORT-RUN TRADE-OFF 24 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

26. THE SHORT-RUN TRADE-OFF 25 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 Y1Y1 P1P1 Y2Y2 B P2P2

27. THE SHORT-RUN TRADE-OFF 26 The 1970s Oil Price Shocks 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. [Are these prices real or nominal?] 38.001/1981 32.501/1980 14.851/1979 10.111/1974 $ 3.561/1973 Oil price per barrel

28. THE SHORT-RUN TRADE-OFF 27 The 1970s Oil Price Shocks Inflation rate (% per year) Unemployment rate (%) Supply shocks & rising expected inflation worsened the PC tradeoff. 1972 73 74 75 76 77 78 79 80 81

29. THE SHORT-RUN TRADE-OFF 28 The Cost of Reducing Inflation  Disinflation: a reduction in the inflation rate  [Not to be confused with deflation, which is a reduction in the price level. … But now you’re confused, right?]

30. THE SHORT-RUN TRADE-OFF 29 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.

31. THE SHORT-RUN TRADE-OFF 30 Disinflationary Monetary Policy Contractionary monetary policy moves economy from 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 LRPC PC 1 natural rate of unemployment A PC 2 C B

32. THE SHORT-RUN TRADE-OFF 31 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 percentage point, must sacrifice 5% of a year’s output.  Can spread cost over time, e.g. To reduce inflation by 6 percentage points, can  sacrifice 30% of GDP for one year  sacrifice 10% of GDP for three years

33. THE SHORT-RUN TRADE-OFF 32 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  This theory is essentially empty but the kind of macroeconomists who thought we would never have a recession like the last one and still can’t believe that it happened (anyone see “Inside Job”?) somehow still believe that it’s meaningful.

34. THE SHORT-RUN TRADE-OFF 33 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  I mean just think about it. Who doesn’t “use all information they have”? That’s trivial. What’s important is that lots of people don’t have a lot information, and, in fact, lots of other people are busy deliberately concealing information that’s relevant.

35. THE SHORT-RUN TRADE-OFF 34 Rational Expectations, Costless Disinflation?  Back to our regularly-scheduled program …  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…

36. THE SHORT-RUN TRADE-OFF 35 Rational Expectations, Costless Disinflation?  Suppose the Fed convinces everyone it is committed to reducing inflation.  Then, expected inflation falls, the short-run PC shifts downward.  Result: Disinflations can cause less unemployment than the traditional sacrifice ratio predicts.  This is a lot like saying that everyone understands that, in the long run, prices don’t matter. But everyone behaves as if they do!

37. THE SHORT-RUN TRADE-OFF 36 Rational Expectations, Costless Disinflation?  Suppose the Fed convinces everyone it is committed to reducing inflation.  Result: Disinflations can cause less unemployment than the traditional sacrifice ratio predicts.  Right. Except if the Fed succeeded in convincing every one of this, it would have an incentive to print more money because it would take people a long time to recognize that they’d been lied to and they wouldn’t realize that P should go up.

38. THE SHORT-RUN TRADE-OFF 37 The Volcker Disinflation Fed Chairman Paul Volcker  Appointed in late 1979 under high inflation & unemployment  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…

39. THE SHORT-RUN TRADE-OFF 38 The Volcker Disinflation Inflation rate (% per year) Unemployment rate (%) Disinflation turned out to be very costly u-rate near 10% in 1982-83 1979 80 81 82 83 84 85 86 87

40. THE SHORT-RUN TRADE-OFF 39 The Greenspan Era  1986: Oil prices fell 50%.  1989-90: Unemployment fell, inflation rose. Fed raised interest rates, caused a mild recession.  1990s: Unemployment and inflation fell.  2001: Negative demand shocks created the first recession in a decade. Policymakers responded with expansionary monetary and fiscal policy. Alan Greenspan Chair of FOMC, Aug 1987 – Jan 2006

41. THE SHORT-RUN TRADE-OFF 40 The Greenspan Era  2001: Negative demand shocks created the first recession in a decade. Policymakers responded with expansionary monetary and fiscal policy.  “Negative demand shocks” is a nice phrase. In this context, it means that lots of people lost a lot of money because they thought that anything related to computers would have to be profitable even though they had no idea how computers worked or what they could be good for and it turned out that … they were wrong.

42. THE SHORT-RUN TRADE-OFF 41 The Greenspan Era Inflation rate (% per year) Unemployment rate (%) Inflation and unemployment were low during most of Alan Greenspan’s years as Fed Chairman. 1987 90 92 2000 94 96 98 06 02 05

43. THE SHORT-RUN TRADE-OFF 42 Ben Bernanke’s challenges  Aggregate demand shocks:  Subprime mortgage crisis, falling housing prices, widespread foreclosures, financial sector troubles.  Aggregate supply shocks:  Rising prices of food/agricultural commodities, e.g., Corn per bushel: $2.10 in 2005-06, $5.76 in 5/2008  Rising oil prices Oil per barrel: $35 in 2/2004, $134 in 6/2008  From 6/2007 to 6/2008,  unemployment rose from 4.6% to 5.5%  CPI inflation rose from 2.6% to 4.9%

44. THE SHORT-RUN TRADE-OFF 43 CONCLUSION  The theories in this chapter come from some of the greatest economists of the 20 th century.  They teach us that inflation and unemployment are  unrelated in the long run  negatively related in the short run [sort of]  affected by expectations, which play an important role in the economy’s adjustment from the short-run to the long run.

45. CHAPTER SUMMARY  The Phillips curve describes the short-run tradeoff between inflation and unemployment.  In the long run, there is no tradeoff: inflation is determined by money growth, while unemployment equals its natural rate.  Supply shocks and changes in expected inflation shift the short-run Phillips curve, making the tradeoff more or less favorable. 44

46. CHAPTER SUMMARY  The Fed can reduce inflation by contracting the money supply, which moves the economy along its short-run Phillips curve and raises unemployment. In the long run, though, expectations adjust and unemployment returns to its natural rate.  Some economists argue that a credible commitment to reducing inflation can lower the costs of disinflation by inducing a rapid adjustment of expectations. 45