The Short-Run Trade-off between Inflation and Unemployment
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1 The Short-Run Trade-off between Inflation and Unemployment 22The Short-Run Trade-off between Inflation and Unemployment
2 The Phillips Curve Phillips curve Origins of the Phillips curve Shows the short-run trade-offBetween inflation and unemploymentOrigins of the Phillips curve1958, economist A. W. Phillips“The relationship between unemployment and the rate of change of money wages in the United Kingdom, 1861–1957”Negative correlation between the rate of unemployment and the rate of inflation
3 The Phillips Curve Origins of the Phillips curve 1960, economists Paul Samuelson & Robert Solow“Analytics of anti-inflation policy”Negative correlation between the rate of unemployment and the rate of inflationPolicymakers: Monetary and fiscal policyTo influence aggregate demandChoose any point on Phillips curveTrade-off: High unemployment and low inflationOr low unemployment and high inflation
4 1 The Phillips Curve Inflation Rate (percent per year) B 6 A 2 4%B67A2UnemploymentRate (percent)The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and unemployment is low.
5 The Phillips CurveAggregate demand (AD), aggregate supply (AS), and the Phillips curvePhillips curveCombinations of inflation and unemploymentThat arise in the short runAs shifts in the aggregate-demand curveMove the economy along the short-run aggregate-supply curve
7 2How the Phillips curve is related to the model of aggregate demand and aggregate supply(a) The Model of AD and AS(b) The Phillips CurveInflationRate(percentper year)PricelevelShort-runaggregatesupplyHigh aggregatedemandPhillips curve106B4%output=16,000BLow aggregatedemand6%16,000unemployment=4%102A15,000unemployment=7%7%output=15,000A2Quantityof outputUnemploymentRate (percent)This figure assumes price level of 100 for year 2020 and charts possible outcomes for the year Panel (a) shows the model of aggregate demand & aggregate supply. If AD is low, the economy is at point A; output is low (15,000), and the price level is low (102). If AD is high, the economy is at point B; output is high (16,000), and the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises when aggregate demand is low, has high unemployment (7%) and low inflation (2%). Point B, which arises when aggregate demand is high, has low unemployment (4%) and high inflation (6%).
8 Shifts in Phillips Curve: Role of Expectations The long-run Phillips curveIs verticalIf the Fed increases the money supply slowlyInflation rate is lowUnemployment – natural rateIf the Fed increases the money supply quicklyInflation rate is highUnemployment - does not depend on money growth and inflation in the long run
9 The long-run Phillips curve 3The long-run Phillips curveInflationRateLong-runPhillips curveNatural rate ofunemploymentHighinflationB1. When theFed increasesthe growth rateof the moneysupply, therate of inflationincreases . . .but unemploymentremains at its natural ratein the long run.LowinflationAUnemploymentRateAccording to Friedman and Phelps, there is no trade-off between inflation and unemployment in the long run. Growth in the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical.
10 Shifts in Phillips Curve: Role of Expectations The long-run Phillips curveExpression of the classical idea of monetary neutralityIncrease in money supplyAggregate-demand curve – shifts rightPrice level – increasesOutput – natural rateInflation rate – increasesUnemployment – natural rate
11 4How the long-run Phillips curve is related to the model of aggregate demand and aggregate supply(a) The Model of AD and AS(b) The Phillips CurveInflationRatePricelevelLong-runaggregate supplyNatural rateof outputLong-runPhillips curveNatural rateof outputP2BAD21. An increase inthe money supplyincreases aggregatedemand . . .BAggregate demand, AD1andincreases theinflation rate . . .P1Araisesthe pricelevel . . .Abut leaves output and unemploymentat their natural rates.Quantity of outputUnemploymentRatePanel (a) shows the model of AD and AS with a vertical aggregate-supply curve. When expansionary monetary policy shifts the AD curve to the right from AD1 to AD2, the equilibrium moves from point A to point B. The price level rises from P1 to P2, while output remains the same. Panel (b) shows the long-run Phillips curve, which is vertical at the natural rate of unemployment. In the long run, expansionary monetary policy moves the economy from lower inflation (point A) to higher inflation (point B) without changing the rate of unemployment
12 Shifts in Phillips Curve: Role of Expectations The meaning of “natural”Natural rate of unemploymentUnemployment rate toward which the economy gravitates in the long runNot necessarily socially desirableNot constant over timeLabor-market policiesAffect the natural rate of unemploymentShift the Phillips curve
13 Shifts in Phillips Curve: Role of Expectations The meaning of “natural”Policy change - reduce the natural rate of unemploymentLong-run Phillips curve shifts leftLong-run aggregate-supply shifts rightFor any given rate of money growth and inflationLower unemploymentHigher output
14 Shifts in Phillips Curve: Role of Expectations Reconciling theory and evidenceExpected inflationDetermines - position of short-run AS curveShort runThe Fed can takeExpected inflation & short-run AS curveAs already determined
15 Shifts in Phillips Curve: Role of Expectations Reconciling theory and evidenceShort runMoney supply changesAD curve shifts along a given short-run AS curveUnexpected fluctuations inOutput & pricesUnemployment & inflationDownward-sloping Phillips
16 Shifts in Phillips Curve: Role of Expectations Reconciling theory and evidenceLong runPeople - expect whatever inflation rate the Fed chooses to produceNominal wages - adjust to keep pace with inflationLong-run aggregate-supply curve is vertical
17 Shifts in Phillips Curve: Role of Expectations Reconciling theory and evidenceLong runMoney supply changesAD curve shifts along a vertical long-run ASNo fluctuations inOutput & unemploymentUnemployment – natural rateVertical long-run Phillips curve
18 Shifts in Phillips Curve: Role of Expectations The short-run Phillips curveUnemployment rate == Natural rate of unemployment –- a(Actual inflation – Expected inflation)Where a - parameter that measures how much unemployment responds to unexpected inflationNo stable short-run Phillips curveEach short-run Phillips curveReflects a particular expected rate of inflationExpected inflation – changesShort-run Phillips curve shifts
19 How expected inflation shifts short-run Phillips curve 5How expected inflation shifts short-run Phillips curveInflationRateLong-runPhillips curveNatural rate ofunemploymentbut in the long run, expectedinflation rises, and the short-runPhillips curve shifts to the right.Short-run Phillips curvewith high expectedinflationBCShort-run Phillips curvewith low expectedinflation1. Expansionary policy movesthe economy up along theshort-run Phillips curve . . .AUnemployment RateThe higher the expected rate of inflation, the higher the short-run trade-off between inflation and unemployment. At point A, expected inflation and actual inflation are equal at a low rate, and unemployment is at its natural rate. If the Fed pursues an expansionary monetary policy, the economy moves from point A to point B in the short run. At point B, expected inflation is still low, but actual inflation is high. Unemployment is below its natural rate. In the long run, expected inflation rises, and the economy moves to point C. At point C, expected inflation and actual inflation are both high, and unemployment is back to its natural rate
20 Shifts in Phillips Curve: Role of Expectations Natural experiment for natural-rate hypothesisNatural-rate hypothesisUnemployment - eventually returns to its normal/natural rateRegardless of the rate of inflationLate 1960s (short-run), policies:Expand AD for goods and services
21 Shifts in Phillips Curve: Role of Expectations Natural experiment for natural-rate hypothesisExpansionary fiscal policyGovernment spending roseVietnam WarMonetary policyThe Fed – try to hold down interest ratesMoney supply – rose 13% per yearHigh inflation (5-6% per year)Unemployment increasedTrade-off
22 The Phillips Curve in the 1960s This figure uses annual data from 1961 to 1968 on the unemployment rate and on the inflation rate (as measured by the GDP deflator) to show the negative relationship between inflation and unemployment.
23 Shifts in Phillips Curve: Role of Expectations Natural experiment for natural-rate hypothesisBy the late 1970s (long-run)Inflation – stayed highUnemployment – natural rateNo trade-off
24 The breakdown of the Phillips Curve 7The breakdown of the Phillips CurveThis figure shows annual data from 1961 to 1973 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The Phillips curve of the 1960s breaks down in the early 1970s, just as Friedman and Phelps had predicted. Notice that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 5.
25 Shifts in Phillips Curve: Role of Supply Shocks Event that directly alters firms’ costs and pricesShifts economy’s aggregate-supply curveShifts the Phillips curve
26 Shifts in Phillips Curve: Role of Supply Shocks Increase in oil priceAggregate-supply curve shifts leftStagflationLower outputHigher pricesShort-run Phillips curve shifts rightHigher unemploymentHigher inflation
27 An adverse shock to aggregate supply 8An adverse shock to aggregate supply(a) The Model of AD and AS(b) The Phillips Curve1. An adverse shiftin aggregate supply . . .giving policymakersa less favorable trade-offbetween unemploymentand inflation.Priceleveland raisesthe price level . . .InflationRatePC2AS2Phillips curve, PC1AggregatedemandAggregatesupply, AS1P2BBY2P1AAY1lowers output . . .Quantity of outputUnemploymentRatePanel (a) shows the model of aggregate demand and aggregate supply. When the aggregate-supply curve shifts to the left from AS1 to AS2, the equilibrium moves from point A to point B. Output falls from Y1 to Y2, and the price level rises from P1 to P2. Panel (b) shows the short-run trade-off between inflation and unemployment. The adverse shift in aggregate supply moves the economy from a point with lower unemployment and lower inflation (point A) to a point with higher unemployment and higher inflation (point B). The short-run Phillips curve shiftsto the right from PC1 to PC2. Policymakers now face a worse trade-off between inflation and unemployment.
28 Shifts in Phillips Curve: Role of Supply Shocks Increase in oil priceAggregate-supply curve shifts leftShort-run Phillips curve shifts rightIf temporary – revert backIf permanent – needs government intervention1970s, 1980s, U.S.The Fed – higher money growthIncrease ADTo accommodate the adverse supply shockHigher inflation
29 The supply shocks of the 1970s This figure shows annual data from 1972 to 1981 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). In the periods 1973–1975 and 1978–1981, increases in world oil prices led to higher inflation and higher unemployment.
30 The Cost of Reducing Inflation October 1979OPEC - second oil shockThe Fed – policy of disinflationContractionary monetary policyAggregate demand – contractsHigher unemployment & Lower inflationOver timePhillips curve shifts leftLower inflationUnemployment – natural rate
31 Disinflationary monetary policy in short run & long run 10Disinflationary monetary policy in short run & long runInflationRateLong-runPhillips curveNatural rate ofunemployment1. Contractionary policy movesthe economy down along theshort-run Phillips curve . . .Short-run Phillips curvewith high expectedinflationAShort-run Phillips curvewith low expected inflationCBbut in the long run, expectedinflation falls, and the short-runPhillips curve shifts to the leftUnemployment RateWhen the Fed pursues contractionary monetary policy to reduce inflation, the economy moves along a short-run Phillips curve from point A to point B. Over time, expected inflation falls, and the short-run Phillips curve shifts downward. When the economy reaches point C, unemployment is back at its natural rate
32 The Cost of Reducing Inflation Sacrifice ratioNumber of percentage points of annual outputLost in the process of reducing inflation by 1 percentage pointRational expectationsPeople optimally use all information they haveIncluding information about government policiesWhen forecasting the future
33 The Cost of Reducing Inflation Possibility of costless disinflationWith rational expectationsSmaller sacrifice ratioIf government - credible commitment to a policy of low inflationPeople – rationalLower heir expectations of inflation immediatelyShort-run Phillips curve - shift downwardEconomy - low inflation quicklyWithout costsTemporarily high unemployment & low output
34 The Cost of Reducing Inflation The Volker disinflationPaul Volker – chairman of the Fed, 1979Peak inflation: 10%Sacrifice ratio = 5Reducing inflation – great costRational expectationsReducing inflation – smaller cost1984 inflation : 4% due to Monetary policyCost: recessionHigh unemployment: 10%Low output
35 The Volcker Disinflation 11The Volcker DisinflationThis figure shows annual data from 1979 to 1987 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The reduction in inflation during this period came at the cost of very high unemployment in 1982 and Note that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 10.
36 The Cost of Reducing Inflation The Volker disinflationRational expectationsCostless disinflationVolker disinflationCost – not as large as predictedThe public – did not believe themWhen he announced monetary policy to reduce inflation
37 The Cost of Reducing Inflation The Greenspan eraAlan Greenspan – chair of the Fed, 1987Favorable supply shock (OPEC, 1986)Falling inflation & falling unemployment: high inflation & low unemploymentThe Fed – raised interest ratesContracted aggregate demand1990s – economic prosperityPrudent monetary policy
38 12The Greenspan EraThis figure shows annual data from 1984 to 2006 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). During most of this period, Alan Greenspan was chairman of the Federal Reserve. Fluctuations in inflation and unemployment were relatively small.
39 The Cost of Reducing Inflation The Greenspan era2001: recessionDepressed aggregate demandExpansionary fiscal and monetary policyBernanke’s challengesBen Bernanke – chair, the Fed, 2006: booming housing marketNew homeowners: subprime (high risk of default)
40 The Cost of Reducing Inflation Bernanke’s challenges: housing & financial crisesHousing prices declined > 15%The new homeowners: underwaterValue of house < balance on mortgageMortgage defaultsHome foreclosuresFinancial institutions – large lossesDepressing the aggregate demand
41 The Cost of Reducing Inflation Bernanke’s challenges: rising commodity pricesIncreased demand from rapidly growing emerging economiesPrices of basic foods – rose significantlyDroughts in AustraliaDemand increase from emerging economiesIncreased use of agricultural products – biofuelsContracting aggregate supply