16 The Trade-off Between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER The Trade-off Between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER

●Demand-Side Inflation versus Supply-Side Inflation: A Review ●Origins of the Phillips Curve ●Supply-Side Inflation and the Collapse of the Phillips Curve ●What the Phillips Curve Is Not ●Demand-Side Inflation versus Supply-Side Inflation: A Review ●Origins of the Phillips Curve ●Supply-Side Inflation and the Collapse of the Phillips Curve ●What the Phillips Curve Is Not Contents Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

●Fighting Unemployment with Fiscal and Monetary Policy ●What Should Be Done? ●Inflationary Expectations and the Phillips Curve ●The Theory of Rational Expectations ●Why Economists (and Politicians) Disagree ●Fighting Unemployment with Fiscal and Monetary Policy ●What Should Be Done? ●Inflationary Expectations and the Phillips Curve ●The Theory of Rational Expectations ●Why Economists (and Politicians) Disagree Contents (continued) Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

●The Dilemma of Demand Management ●Attempts to Reduce the Natural Rate of Unemployment ●Indexing ●The Dilemma of Demand Management ●Attempts to Reduce the Natural Rate of Unemployment ●Indexing Contents (continued) Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  AD  ♦  prices ♦  output ●  AS  ♦  prices ♦  output ●  AD  ♦  prices ♦  output ●  AS  ♦  prices ♦  output Demand-Side Inflation versus Supply-Side Inflation

FIGURE 1: Inflation from the Demand Side Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. S S D 0 D 0 Price Level Real GDP A D 1 D 1 B

FIGURE 2: Inflation from the Supply Side Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP A S 1 S 1 B

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Origins of the Phillips Curve ●If  GDP are primarily caused by  AD: ♦Higher rates of inflation will be associated with lower rates of unemployment ♦Lower rates of inflation will be associated with higher rates of unemployment ●The U.S. data for show such a relationship. ●If  GDP are primarily caused by  AD: ♦Higher rates of inflation will be associated with lower rates of unemployment ♦Lower rates of inflation will be associated with higher rates of unemployment ●The U.S. data for show such a relationship.

FIGURE 3: Origins of the Phillips Curve Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. 3% 1% 2% 6% A B Inflation Rate 5%4% C Unemployment Rate

FIGURE 5: A Phillips Curve for the U.S., Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. 7% Inflation Rate 1 Unemployment Rate in Percent

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Supply-Side Inflation and the Collapse of Phillips Curve ●If  GDP are primarily caused by  AS: ♦Higher rates of inflation will be associated with higher rates of unemployment ♦Lower rates of inflation will be associated with lower rates of unemployment ●The U.S. data for and show such a relationship. ●If  GDP are primarily caused by  AS: ♦Higher rates of inflation will be associated with higher rates of unemployment ♦Lower rates of inflation will be associated with lower rates of unemployment ●The U.S. data for and show such a relationship.

FIGURE 6: A Phillips Curve for the U.S.? Copyright © 2006 South-Western/Thomson Publishing. All rights reserved % Inflation Rate 1 Unemployment Rate in Percent

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Supply-Side Inflation and the Collapse of Phillips Curve ●Explaining the Fabulous 1990s ♦Favorable supply shock  AS curve shifts out ♦Characterizes the U.S. economy from 1996 to 1998 ■GDP grew rapidly ■Both inflation and unemployment fell ●Explaining the Fabulous 1990s ♦Favorable supply shock  AS curve shifts out ♦Characterizes the U.S. economy from 1996 to 1998 ■GDP grew rapidly ■Both inflation and unemployment fell

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 7: The Effects of a Favorable Supply Shock Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Price Level Real GDP Effect of favorable supply shock Normal growth of aggregate supply D 0 D 0 S 0 S 0 D 1 D 1 S 1 S 1 B C A

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●Phillips Curve = curve showing a short-run trade-off between unemployment and inflation ♦Only applies if  AD ♦Not a stable, long-run menu of choices ●Phillips Curve = curve showing a short-run trade-off between unemployment and inflation ♦Only applies if  AD ♦Not a stable, long-run menu of choices

FIGURE 8: The Elimination of a Recessionary Gap Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Price Level Real GDP S 0 S 0 S 2 S 2 S 1 S 1 D D A B Potential GDP C

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●In the long run,  AD  : ♦  inflation ♦ But  AD does not   unemployment ●Long-run effects due to the self-correcting mechanism of the economy ●In the long run,  AD  : ♦  inflation ♦ But  AD does not   unemployment ●Long-run effects due to the self-correcting mechanism of the economy

FIGURE 9: The Vertical Long-Run Phillips Curve Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Inflation Rate Unemployment Rate in Percent g c f e 8% a d

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●Natural rate of unemployment = level of unemployment that is sustainable in the long run ●Corresponds to the “full-employment” unemployment rate ●Natural rate of unemployment = level of unemployment that is sustainable in the long run ●Corresponds to the “full-employment” unemployment rate

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fighting Unemployment with Fiscal and Monetary Policy ●Policy choices if high unemployment: ♦Use expansionary fiscal and monetary policy ■  unemployment ■  inflation ♦Rely on economy’s self-correcting mechanism ■  unemployment without  inflation ■Problem: may take a long time to reduce unemployment ●Policy choices if high unemployment: ♦Use expansionary fiscal and monetary policy ■  unemployment ■  inflation ♦Rely on economy’s self-correcting mechanism ■  unemployment without  inflation ■Problem: may take a long time to reduce unemployment

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What Should be Done? ●Active versus passive monetary and fiscal policy ♦How the public rates the relative costs of unemployment and inflation ♦Slope of the short-run Phillips curve ♦Efficiency of the economy’s self-correcting mechanism ●Active versus passive monetary and fiscal policy ♦How the public rates the relative costs of unemployment and inflation ♦Slope of the short-run Phillips curve ♦Efficiency of the economy’s self-correcting mechanism

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Inflationary Expectations and the Phillips Curve ●Inflation does not erode real wages if: ♦Workers can see inflation coming ♦They receive compensation for it ●But if real wages do not fall, firms have no incentives to increase production. ●Inflation does not erode real wages if: ♦Workers can see inflation coming ♦They receive compensation for it ●But if real wages do not fall, firms have no incentives to increase production.

TABLE 1: Money & Real Wages under Unexpected Inflation Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

TABLE 2: Money and Real Wages under Expected Inflation Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●When inflation is predicted accurately: ♦The short-run AS curve is vertical at potential GDP ♦The short-run Phillips curve is vertical at the natural rate of unemployment ●When inflation is underestimated: ♦ The short-run AS curve and the short-run Phillips curve slope upward ●When inflation is predicted accurately: ♦The short-run AS curve is vertical at potential GDP ♦The short-run Phillips curve is vertical at the natural rate of unemployment ●When inflation is underestimated: ♦ The short-run AS curve and the short-run Phillips curve slope upward Inflationary Expectations and the Phillips Curve

FIGURE 10: Vertical AS Curve and the Vertical Phillips Curve Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Vertical short-run Phillips curve Inflation Rate (b) Unemployment Rate Vertical aggregate supply curve Price Level (a) Real GDP 5 S S

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Rational expectations = forecasts that are the best that can be made given the available data ♦Not necessarily correct ♦No systematic errors ●Rational expectations = forecasts that are the best that can be made given the available data ♦Not necessarily correct ♦No systematic errors The Theory of Rational Expectations

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●If expectations of inflation are rational: ♦The short-run Phillips Curve is vertical ♦Inflation can be reduced without the need for a period of high unemployment ●If expectations of inflation are rational: ♦The short-run Phillips Curve is vertical ♦Inflation can be reduced without the need for a period of high unemployment

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●Reasons that expectations are not completely rational ♦Contracts may embody outdated expectations ♦Expectations may adjust slowly ♦Workers likely receive compensation for inflation after the fact ●Reasons that expectations are not completely rational ♦Contracts may embody outdated expectations ♦Expectations may adjust slowly ♦Workers likely receive compensation for inflation after the fact

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●In the long run, expectations should be rational. ♦People should not cling to incorrect expectations indefinitely. ●In the long run, expectations should be rational. ♦People should not cling to incorrect expectations indefinitely.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Economists (and Politicians) Disagree ●Why Keynesians and liberals are more eager to fight unemployment ♦Unemployment is more costly than inflation ♦The short-run Phillips Curve is flat ♦Expectations react sluggishly ♦The self-correcting mechanism is slow or unreliable ●Why Keynesians and liberals are more eager to fight unemployment ♦Unemployment is more costly than inflation ♦The short-run Phillips Curve is flat ♦Expectations react sluggishly ♦The self-correcting mechanism is slow or unreliable

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Economists (and Politicians) Disagree ●Why rational expectations, adherents, and conservatives are more eager to fight inflation ♦Inflation is more costly than unemployment ♦The short-run Phillips curve is steep ♦Expectations react quickly ♦The economy’s self-correcting mechanism works smoothly and rapidly ●Why rational expectations, adherents, and conservatives are more eager to fight inflation ♦Inflation is more costly than unemployment ♦The short-run Phillips curve is steep ♦Expectations react quickly ♦The economy’s self-correcting mechanism works smoothly and rapidly

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Dilemma of Demand Management ●Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment. ♦True whether inflation is due to a shock to AD or AS ♦Government only has control over AD curve ●Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment. ♦True whether inflation is due to a shock to AD or AS ♦Government only has control over AD curve

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Attempts to Reduce Natural Rate of Unemployment ●The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment. ♦Education ♦Training ♦Job placement services ●The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment. ♦Education ♦Training ♦Job placement services

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Attempts to Reduce Natural Rate of Unemployment ●Problems ♦Training and placement programs often look better on paper than they do in practice, where they achieve only modest successes. ♦The high cost of these programs restricts the number of workers that can be accommodated, even when they work. ●Problems ♦Training and placement programs often look better on paper than they do in practice, where they achieve only modest successes. ♦The high cost of these programs restricts the number of workers that can be accommodated, even when they work.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Indexing ●Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes ♦Wages ♦Pensions ♦Interest payments on bonds ♦Income taxes ●Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes ♦Wages ♦Pensions ♦Interest payments on bonds ♦Income taxes

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Indexing ●Indexing protects people from the costs of inflation. ●But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it. ●Indexing protects people from the costs of inflation. ●But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it.