1. Copyright © 2004 South-Western 22 The Short-Run Tradeoff between Inflation and Unemployment

2. Copyright © 2004 South-Western Unemployment and Inflation The natural rate of unemployment depends on various features of the labor market. Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.

3. Copyright © 2004 South-Western Unemployment and Inflation Society faces a short-run tradeoff between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

4. Copyright © 2004 South-Western THE PHILLIPS CURVE The Phillips curve illustrates the short-run relationship between inflation and unemployment.

5. Copyright © 2004 South-Western Figure 1 The Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B 6 7 A 2

6. Copyright © 2004 South-Western Aggregate Demand, Aggregate Supply, and the Phillips Curve The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. It is drawn for one level of AS. A shift of AS will generate a new level of the Phillips curve.

7. Copyright © 2004 South-Western Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output 0 Short-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level (b) The Phillips Curve Phillips curve Low aggregate demand High aggregate demand (output is 8,000) B 4 6 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7,500 102 A

8. Copyright © 2004 South-Western The Long-Run Phillips Curve Long-run Phillips curve is vertical It represents the natural rate of unemployment It may be shifted by changes in the labor market, such as increases in unemployment compensation, changes in minimum wage laws.

9. Copyright © 2004 South-Western Figure 3 The Long-Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve B High inflation Low inflation A 2.... but unemployment remains at its natural rate in the long run. 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases...

10. Copyright © 2004 South-Western Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level P Aggregate demand,AD Long-run aggregate supply Long-run Phillips curve (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve 2.... raises the price level... 1. An increase in the money supply increases aggregate demand... A AD 2 B A 4.... but leaves output and unemployment at their natural rates. 3.... and increases the inflation rate... P2P2 B

11. Copyright © 2004 South-Western This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation. Expectations and the Short-Run Phillips Curve Unemployment Rate =

12. Copyright © 2004 South-Western Figure 5 How Expected Inflation Shifts the Short- Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short-run Phillips curve... 2.... but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B A

13. Copyright © 2004 South-Western The Natural Experiment for the Natural-Rate Hypothesis The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. Historical observations support the natural-rate hypothesis.

14. Copyright © 2004 South-Western Figure 6 The Phillips Curve in the 1960s 123456789100 2 4 6 8 Unemployment Rate (percent) Inflation Rate (percent per year) 1968 1966 1961 1962 1963 1967 1965 1964

15. Copyright © 2004 South-Western Figure 7 The Shift of the Phillips Curve 123456789100 2 4 6 8 Unemployment Rate (percent) Inflation Rate (percent per year) 1973 1966 1972 1971 1961 1962 1963 1967 1968 1969 1970 1965 1964

16. Copyright © 2004 South-Western SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS The short-run Phillips curve also shifts because of shocks to aggregate supply. Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

17. Copyright © 2004 South-Western Figure 8 An Adverse Shock to Aggregate Supply Quantity of Output 0 Price Level Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve 3.... and raises the price level... AS 2 Aggregate supply,AS A 1. An adverse shift in aggregate supply... 4.... giving policymakers a less favorable tradeoff between unemployment and inflation. B P2P2 Y2Y2 P A Y Phillips curve,PC 2.... lowers output... PC 2 B

18. Copyright © 2004 South-Western Figure 9 The Supply Shocks of the 1970s 123456789100 2 4 6 8 Unemployment Rate (percent) Inflation Rate (percent per year) 1972 1975 1981 1976 1978 1979 1980 1973 1974 1977

19. Copyright © 2004 South-Western THE COST OF REDUCING INFLATION policyTo reduce inflation, the Fed has to pursue contractionary monetary policy. When the Fed slows the rate of money growth, it contracts aggregate demand. This reduces the quantity of goods and services that firms produce. This leads to a rise in unemployment.

20. Copyright © 2004 South-Western Figure 10 Disinflationary Monetary Policy in the Short Run and the Long Run Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve... 2.... but in the long run, expected inflation falls, and the short-run Phillips curve shifts to the left. B C A

21. Copyright © 2004 South-Western THE COST OF REDUCING INFLATION To reduce inflation, an economy must endure a period of high unemployment and low output. When the Fed combats inflation, the economy moves down the short-run Phillips curve. The economy experiences lower inflation but at the cost of higher unemployment.

22. Copyright © 2004 South-Western Rational Expectations and the Possibility of Costless Disinflation Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run. How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.

23. Copyright © 2004 South-Western The Volcker Disinflation When Paul Volcker became Fed chairman in the 1980, inflation was widely viewed as one of the nation’s foremost problems. Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high unemployment (about 10 percent in 1983).

24. Copyright © 2004 South-Western Figure 11 The Volcker Disinflation 123456789100 2 4 6 8 Unemployment Rate (percent) Inflation Rate (percent per year) 1980 1981 1982 1984 1986 1985 1979 A 1983 B 1987 C

25. Copyright © 2004 South-Western Figure 12 The Greenspan Era 12345678910 0 2 4 6 8 Unemployment Rate (percent) Inflation Rate (percent per year) 1984 1991 1985 1992 1986 1993 1994 1988 1987 1995 1996 2002 1998 1999 2000 2001 1989 1990 1997

26. Copyright © 2004 South-Western Positive changes in Aggregate Supply The best way to achieve low inflation and low unemployment is to experience an increase in the aggregate supply. Increase in AS moves Phillips curve to a lower level, giving the government a better trade-off between inflation and unemployment. Example: technological change in the 1990s. Problem: AS cannot be freely changed by government policy.