1. The Short-Run Tradeoff between Inflation and Unemployment
Chapter 33
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2. 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.

3. Unemployment and Inflation
The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.
The misery index, one measure of the “health” of the economy, adds together the inflation rate and unemployment rate.

4. 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.

5. The Phillips Curve
The Phillips curve illustrates the short-run relationship between inflation and unemployment.

6. The Phillips Curve... Inflation Rate (percent per year) 4 B 6 A 7 2
Unemployment Rate (percent)

7. 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.

8. Aggregate Demand, Aggregate Supply, and the Phillips Curve
The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.
A higher level of output results in a lower level of unemployment.

9. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply...
(a) The Model of AD and AS
(b) The Phillips Curve
Short-run AS
Inflation Rate (percent per year)
Price Level B
8,000
106
(unemployment is 7%) B 4 6
(output is 8,000)
High AD A
7,500
102
(unemployment is 7%) A 7 2
(output is 7,500)
Low AD
Phillips curve
Unemployment Rate (percent)

10. Shifts in the Phillips Curve: The Role of Expectations
The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

11. The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.
Monetary policy could be effective in the short run but not in the long run.

12. The Long-Run Phillips Curve...
Inflation Rate
Long-run Phillips curve B
High inflation
1. When the Fed increases the growth rate of the money supply, the rate of inflation increases…
2. … but unemployment remains at its natural rate
in the long run. A
Low inflation
Unemployment Rate
Natural rate of unemployment

13. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply…
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price Level
Long-run aggregate supply
Inflation Rate
Long-run Phillips curve
1. An increase in the money supply increases aggregate demand…
AD2 B
3. …and increases the inflation rate… P2
2. …raises the price level… P1 A
Aggregate demand, AD1
Natural rate of output
Quantity of
Output
Natural rate of unemployment
Unemploy-ment Rate
4. …but leaves output and unemployment at their natural rates.

14. Expectations and the Short-Run Phillips Curve
Expected inflation measures how much people expect the overall price level to change.

15. Expectations and the Short-Run Phillips Curve
In the long run, expected inflation adjusts to changes in actual inflation.
The Fed’s ability to create unexpected inflation exists only in the short run.
Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

16. Expectations and the Short-Run Phillips Curve
Actual Expected inflation inflation -
Unemployment Rate
Natural rate of unemployment - a ( ) =
This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.

17. How Expected Inflation Shifts the Short-Run Phillips Curve...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How Expected Inflation Shifts the Short-Run Phillips Curve...
Inflation
Rate
Long-run Phillips curve
2. …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B
Short-run Phillips curve with high expected inflation
1. Expansionary policy moves the economy up along the short-run Phillips curve... A
Short-run Phillips curve with low expected inflation
Unemployment Rate
Natural rate of unemployment

18. 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.

19. The Natural Experiment for the Natural Rate Hypothesis
The concept of a stable Phillips curve broke down in the in the early ’70s.
During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

20. The Phillips Curve in the 1960s...
Inflation Rate
(percent per year) 10 8 6
1968
1966
1961
1962
1963
1967
1965
1964 4 2 1 2 3 4 5 6 7 8 9 10
Unemployment Rate (percent)

21. The Breakdown of the Phillips Curve...
Inflation Rate
(percent per year) 10 8
1973
1971
1969
1970
1968
1966
1961
1962
1963
1967
1965
1964
1972 6 4 2 1 2 3 4 5 6 7 8 9 10
Unemployment Rate (percent)

22. Shifts in the Phillips Curve: The Role of Supply Shocks
Historical events have shown that the short-run Phillips curve can shift due to changes in expectations.

23. 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.

24. Shifts in the Phillips Curve: The Role of Supply Shocks
A supply shock is an event that directly affects firms’ costs of production and thus the prices they charge.
It shifts the economy’s aggregate supply curve...
… and as a result, the Phillips curve.

25. An Adverse Shock to Aggregate Supply...
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve B
4. …giving policymakers a less favorable tradeoff between unemployment and inflation.
PC2 P2
3. …and raises the price level…
Price Level
Inflation Rate
AS2
1. An adverse shift in aggregate supply…
Aggregate supply, AS1 B
2. …lowers output… Y2 A A P1
Aggregate demand
Phillips curve, PC1 Y1
Quantity of
Output
Unemployment Rate

26. Shifts in the Phillips Curve: The Role of Supply Shocks
In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum.
Fight the unemployment battle by expanding aggregate demand and accelerate inflation.
Fight inflation by contracting aggregate demand and endure even higher unemployment.

27. The Supply Shocks of the 1970s...
Inflation Rate
(percent per year) 10
1972
1975
1981
1976
1978
1979
1980
1973
1974
1977 8 6 4 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

28. The Cost of Reducing Inflation
To 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.

29. Disinflationary Monetary Policy in the Short Run and the Long Run...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Disinflationary Monetary Policy in the Short Run and the Long Run...
Inflation Rate A
Short-run Phillips curve
with high expected
inflation
1. Contractionary policy moves the economy down along the short-run Phillips curve...
Long-run
Phillips curve C B
Short-run Phillips curve
with low expected
inflation
but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left.
Natural rate of
unemployment
Unemployment
Rate

30. 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.

31. The Cost of Reducing Inflation
The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.
An estimate of the sacrifice ratio is five.
To reduce inflation from about 10% in to 4% would have required an estimated sacrifice of 30% of annual output!

32. Rational Expectations
The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

33. Rational Expectations
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.

34. Rational Expectations
The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.

35. The Volcker Disinflation
When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the nation’s foremost problems.
Volcker succeeded in reducing inflation (from 10% to 4%), but at the cost of high employment (about 10% in 1983).

36. The Volcker Disinflation...
Inflation Rate
(percent per year) 10
1979
1980
1983
1981
1982
1984
1986
1987
1985 A B C 8 6 4 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

37. The Greenspan Era
Alan Greenspan’s term as Fed chairman began with a favorable supply shock.
In 1986, OPEC members abandoned their agreement to restrict supply.
This led to falling inflation and falling unemployment.

38. The Greenspan Era... Inflation Rate (percent per year) 10 8 6 1984
1991
1985
1992
1993
1986
1994
1988
1987
1995
1989
1990 4 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

39. The Greenspan Era
Fluctuations in inflation and unemployment in recent years have been relatively small due to the Fed’s actions.

40. Summary
The Phillips curve describes a negative relationship between inflation and unemployment.
By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment.
By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.

41. Summary
The tradeoff between inflation and unemployment described by the Phillips curve holds only in the short run.
The long-run Phillips curve is vertical at the natural rate of unemployment.

42. Summary
The short-run Phillips curve also shifts because of shocks to aggregate supply.
An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

43. Summary
When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve.
This results in temporarily high unemployment.
The cost of disinflation depends on how quickly expectations of inflation fall.

44. Summary
Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy.
Changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment.

45. Graphical Review

46. The Phillips Curve... Unemployment Rate (percent)
Inflation Rate (percent per year) 4 B 6 A 7 2
Phillips curve

47. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply...
(b) The Phillips Curve
Inflation Rate (percent per year)
Unemployment Rate (percent)
(a) The Model of AD and AS
Price Level
Low AD
High AD B 4 6
(output is 8,000) A 7 2
(output is 7,500)
7,500
102
(unemployment is 7%)
8,000
106
Short-run AS

48. The Long-Run Phillips Curve...
Unemployment Rate
Natural rate of unemployment
Inflation Rate
Long-run Phillips curve B
High inflation
1. When the Fed increases the growth rate of the money supply, the rate of inflation increases…
2. … but unemployment remains at its natural rate
in the long run. A
Low inflation

49. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply…
Natural rate of unemployment
Long-run Phillips curve
(b) The Phillips Curve
Inflation Rate A
Natural rate of output P1
Aggregate demand, AD1
Long-run aggregate supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price Level
4. …but leaves output and unemployment at their natural rates. P2
2. …raises the price level…
Quantity of
Output
Unemploy-ment Rate
1. An increase in the money supply increases aggregate demand…
AD2 B
3. …and increases the inflation rate…

50. How Expected Inflation Shifts the Short-Run Phillips Curve...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How Expected Inflation Shifts the Short-Run Phillips Curve...
Unemployment Rate
Natural rate of unemployment
Inflation
Rate C B
Long-run Phillips curve A
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.

51. The Phillips Curve in the 1960s...
Unemployment Rate (percent)
Inflation Rate
(percent per year) 1 2 3 4 5 6 7 8 9 10
1968
1966
1961
1962
1963
1967
1965
1964

52. The Breakdown of the Phillips Curve...
Unemployment Rate (percent)
Inflation Rate
(percent per year) 1 2 3 4 5 6 7 8 9 10
1973
1971
1969
1970
1968
1966
1961
1962
1963
1967
1965
1964
1972

53. An Adverse Shock to Aggregate Supply...
AS2
1. An adverse shift in aggregate supply…
Quantity of
Output
Price Level P1
Aggregate demand
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment Rate
(b) The Phillips Curve A
Inflation Rate
Phillips curve, PC1
Aggregate supply, AS1 Y1 P2
3. …and raises the price level… B
2. …lowers output… Y2
4. …giving policymakers a less favorable tradeoff between unemployment and inflation.
PC2

54. The Supply Shocks of the 1970s...
Inflation Rate
(percent per year)
Unemployment
Rate (percent) 1 2 3 4 5 6 7 8 9 10
1972
1975
1981
1976
1978
1979
1980
1973
1974
1977

55. Disinflationary Monetary Policy in the Short Run and the Long Run...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Disinflationary Monetary Policy in the Short Run and the Long Run... A
Short-run Phillips curve
with high expected
inflation
1. Contractionary policy moves the economy down along the short-run Phillips curve...
Unemployment
Rate
Natural rate of
unemployment
Inflation Rate
Long-run
Phillips curve C B
with low expected
but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left.

56. The Volcker Disinflation...
Unemployment
Rate (percent)
Inflation Rate
(percent per year) 1 2 3 4 5 6 7 8 9 10
1979
1980
1983
1981
1982
1984
1986
1987
1985 A B C

57. The Greenspan Era... Unemployment Rate (percent) 1 2 3 4 5 6 7 8 9 101 2 3 4 5 6 7 8 9 10
Inflation Rate
(percent per year)
1984
1991
1985
1992
1993
1986
1994
1988
1987
1995
1989
1990