1. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 30 The Phillips Curve The Relationship Between Inflation and Unemployment An inverse relationship between inflation and unemployment until the 1970s 1970s  high inflation and unemployment Is there still a relationship between inflation and unemployment? The Relationship Between Inflation and Unemployment An inverse relationship between inflation and unemployment until the 1970s 1970s  high inflation and unemployment Is there still a relationship between inflation and unemployment?

2. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 30 The 1960s: A Policy Menu?

3. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 30 Phillips curve A curve showing the short- run relationship between the unemployment rate and the inflation rate. The Discovery of the Short-Run Trade-off between Unemployment and Inflation The Phillips Curve

4. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 30 Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve The Discovery of the Short-Run Trade-off between Unemployment and Inflation

5. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 30 1970s: Why did the Phillips curve vanish? higher oil prices inflation became persistent and positive

6. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 30 Is the Phillips Curve a Policy Menu? Is the Short-Run Phillips Curve Stable? During the 1960s, the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation. Then in 1968, in his presidential address to the American Economic Association, Milton Friedman of the University of Chicago argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. The Long-Run Phillips Curve Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

7. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 30 The Long-Run Phillips Curve A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

8. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 30 The Role of Expectations of Future Inflation The Basis for the Short-Run Phillips Curve IF…THEN…AND… actual inflation is greater than expected inflation, the actual real wage is less than the expected real wage, labor is cheap … the unemployment rate falls. actual inflation is less than expected inflation, the actual real wage is greater than the expected real wage, labor is dear … the unemployment rate rises.

9. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 30 The Short-Run and Long-Run Phillips Curves The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve

10. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 30 The Short-Run and Long-Run Phillips Curves The Inflation Rate and the Natural Rate of Unemployment in the Long Run Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease.

11. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 30 Does the Natural Rate of Unemployment Ever Change? Making the Connection Frictional or structural unemployment can change— thereby changing the natural rate—for several reasons: Demographic changes. Labor market institutions. Strength of unions Generous unemployment benefits Past high rates of unemployment. Other costs of production and the real wage Oil price and the “natural rate”

12. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 30 Low inflation. Moderate but stable inflation. High and unstable inflation. Expectations of the Inflation Rate and Monetary Policy Rational expectations Expectations formed by using all available information about an economic variable. The experience in the United States over the past 50 years indicates that how workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities:

13. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 30 Expectations of the Inflation Rate and Monetary Policy The Effect of Rational Expectations on Monetary Policy Rational Expectations and the Phillips Curve Rational expectations Expectations formed by using all available information about an economic variable, including what you’ve learned in college. Rational expectations  Policy ineffectiveness  Don’t bother with expansionary policy  Laissez - faire Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP.

14. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 30 Many economists remain skeptical that the short-run Phillips curve is vertical. (1)workers and firms actually may not have rational expectations, and (2)the rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place. Is the Short-Run Phillips Curve Really Vertical?

15. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 30 How the Fed Fights Inflation Paul Volcker and Disinflation The Fed Tames Inflation, 1979–1989

16. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 30 FEDERAL RESERVE CHAIRMAN TERM AVERAGE ANNUAL INFLATION RATE DURING TERM William McChesney MartinApril 1952-January 19702.0% Arthur BurnsFebruary 1970-January 19786.5 G. William MillerMarch 1978-August 19799.2 Paul VolckerAugust 1979-August 19876.2 Alan GreenspanAugust 1987-(January 2006)3.0 Ben BernankeJanuary 2006–3.0 How the Fed Fights Inflation De-emphasizing the Money Supply The Fed learned an important lesson during the1970s: Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective.

17. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 30 How the Fed Fights Inflation Monetary Policy Credibility after Greenspan Central banks are more credible if they adopt and follow rules. Rules (e.g., Taylor Rule) vs. discretion A middle course between rules and discretion: Inflation targeting. The best way to achieve commitment to rules  remove political pressures on the central bank.

18. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 30 An Inside LOOK The Fed Rethinks the Phillips Curve Policy Makers at Fed Rethink Inflation’s Roots The short- and long-run Phillips curves.

19. Chapter 16: Inflation, Unemployment, and Federal Reserve Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 30 K e y T e r m s Disinflation Natural rate of unemployment Nonaccelerating inflation rate of unemployment (NAIRU) Phillips curve Rational expectations Real business cycle models Structural relationship