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 E conomics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 35

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.  One of the Ten Principles: In the short run, society faces a trade-off between inflation and unemployment.

4. AGGREGATE DEMAND AND AGGREGATE SUPPLY 3 Classical Economics—A Recap  The previous chapters are based on the ideas of classical economics, especially:  The Classical Dichotomy, the separation of variables into two groups:  Real – quantities, relative prices  Nominal – measured in terms of money  The neutrality of money: Changes in the money supply affect nominal but not real variables.

5. AGGREGATE DEMAND AND AGGREGATE SUPPLY 4 Classical Economics—A Recap  Most economists believe classical theory describes the world in the long run, but not the short run.  In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).  To study the short run, we use a new model.

6. Non-Neutrality of Money Money has no real effect in the long run. Money has real effects in the short run. Monetary shock could be a source of economic fluctuation Monetary policy could stabilize economic fluctuation Three theories of the non-neutrality All based on some market imperfection

7. AGGREGATE DEMAND AND AGGREGATE SUPPLY 6 1. The Sticky-Wage Theory  Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly.  Due to labor contracts, social norms  Firms and workers set the nominal wage in advance based on P E, the price level they expect to prevail.

8. AGGREGATE DEMAND AND AGGREGATE SUPPLY 7 1. The Sticky-Wage Theory  If P > P E, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment.  Hence, higher P causes higher Y.

9. AGGREGATE DEMAND AND AGGREGATE SUPPLY 8 2. The Sticky-Price Theory  Imperfection: Many prices are sticky in the short run.  Due to menu costs, the costs of adjusting prices.  Examples: cost of printing new menus, the time required to change price tags  Firms set sticky prices in advance based on P E.

10. AGGREGATE DEMAND AND AGGREGATE SUPPLY 9 2. The Sticky-Price Theory  Suppose the Fed increases the money supply unexpectedly. Nominal interest rate goes down. People are inclined to consume more today but less tomorrow. Prices are expected to rise today but fall tomorrow.  In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Tomorrow’s inflation rate is expected to fall slowly, less than the fall in nominal interest rate. Thus, real interest rate falls. This boosts consumption today. Thus, GDP rises in the short run.

11. THE SHORT-RUN TRADE-OFF 10

12. AGGREGATE DEMAND AND AGGREGATE SUPPLY 11 3. The Misperceptions Theory 人們在做決策時，需要知道物價。 但由於資訊不完全，人們在做決策時，無法立 即知道真實的物價，只能依預測的物價來做決 策。 預期的物價 (perceived price level) 未必與市場上 的實際物價 (actual price level) 相同。這是 price misperception. 由於 price misperception ，貨幣政策會有實質面 的效果。

13. 假設政府增加貨幣供給，造成物價全面上升。 種芒果的農夫也看到了芒果的價格上漲了。 可是果農對總體物價的認知沒有調整很快，他並不 知道現在各個商品其實都上漲。 果農推論 : 芒果的實質價格 ( 芒果價格 / 物價水準 ) 上 升了，多賣一些會提高實質所得，所以果農決定增 加芒果的供給。果農又多雇一些人手來生產，提高 了勞動需求，造成就業增加。 如果沒有 misperception ，果農會知道芒果的實質價 格其實沒有改變，所以不會改變原定的供給決策。

14. 島嶼寓言 : 每個人的生活像是處在一個孤島 總體經濟像是由成千上萬個島嶼組合而成 島內的資訊完全流通，但島嶼間的資訊流通 需要時間。 每個人可以正確地解讀自己周遭的資訊，但 對總體的資訊只能以手上所能掌握的部份資 訊來推估，可能會推估錯誤。

15. 假設政府在每個島嶼都增加了貨幣供給，結 果每個島嶼的物價都上升了。 雖然這是全國全面性的物價上漲，但身處芒 果島的農夫，只看到芒果島內的物價上漲， 但並不很明白其他地區也在上漲。 農夫可能會將芒果價格上漲解釋成 : 有可能 是對芒果的需求上升所致。所以農夫願意增 加芒果生產。

16. 依 Price Misperception Theory ，人們未能預 期到的貨幣政策的變動 (unanticipated monetary shock) 會有實質效果。 預期到的貨幣政策的變動 (anticipated monetary shock) 沒有實質效果，因為在這種 情形下，人們沒有 misperception 。

17. THE SHORT-RUN TRADE-OFF 16 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.”

18. THE SHORT-RUN TRADE-OFF 17 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.

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

20. THE SHORT-RUN TRADE-OFF 19 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

21. 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... Copyright © 2004 South-Western

22. THE SHORT-RUN TRADE-OFF 21 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.

23. THE SHORT-RUN TRADE-OFF 22 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.

24. THE SHORT-RUN TRADE-OFF 23 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 –

25. THE SHORT-RUN TRADE-OFF 24 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

26. 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 25

27. A C T I V E L E A R N I N G 1 Answers 26 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.

28. THE SHORT-RUN TRADE-OFF 27 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

29. THE SHORT-RUN TRADE-OFF 28 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

30. The short-run Phillips curve also shifts because of shocks to aggregate supply: where s is a supply shock or a cost-push shock.

31. A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. This shifts the economy’s aggregate supply curve and as a result, the Phillips curve.

32. 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.

33. THE SHORT-RUN TRADE-OFF 32 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. 38.001/1981 32.501/1980 14.851/1979 10.111/1974 $ 3.561/1973 Oil price per barrel

34. THE SHORT-RUN TRADE-OFF 33 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

35. THE SHORT-RUN TRADE-OFF 34 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.

36. THE SHORT-RUN TRADE-OFF 35 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

37. THE SHORT-RUN TRADE-OFF 36 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%, must sacrifice 5% of a year’s output.  Can spread cost over time, e.g. To reduce inflation by 6%, can either  sacrifice 30% of GDP for one year  sacrifice 10% of GDP for three years

38. THE SHORT-RUN TRADE-OFF 37 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  Early proponents: Robert Lucas, Thomas Sargent, Robert Barro  Implied that disinflation could be much less costly…

39. THE SHORT-RUN TRADE-OFF 38 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.

40. THE SHORT-RUN TRADE-OFF 39 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…

41. THE SHORT-RUN TRADE-OFF 40 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

42. THE SHORT-RUN TRADE-OFF 41 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

43. THE SHORT-RUN TRADE-OFF 42 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

44. THE SHORT-RUN TRADE-OFF 43 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%

45. THE SHORT-RUN TRADE-OFF 44 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  affected by expectations, which play an important role in the economy’s adjustment from the short-run to the long run.

46. 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. 45

47. 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. 46