chapter 35

355

C H A P T E R

35The Short-Run Trade-off between Infl ation and Unemployment

Goalsin this chapter you will

Learn why policymakers face a short-run trade-off between infl ation and unemployment

Consider why the infl ation-unemployment trade-off disappears in the long run

See how supply shocks can shift the infl ation-unemployment trade-off

Consider the short-run cost of reducing the rate of infl ation

See how policymakers’ credibility aff ects the cost of reducing infl ation

Outcomesafter accomplishing these goals, you should be able to

Draw a graph of a short-run Phillips curve

Draw a graph of a long-run Phillips curve

Show the relationship between a shift in the short-run aggregate-supply curve and a shift in the short-run Phillips curve

356 Chapter 35 the short-run trade-off between inflation and unemPloyment

Strive for a FiveContent from Chapter 35 will be tested on the AP macroeconomics exam. Recently, it has been tested in the free response portion as well as the multiple-choice section. You should be prepared to create and explain a model of the Phillips curve with the long-run Phillips curve displayed.

The Phillips curve■■

Long-run Phillips curve■■

Changes in the Philips curve as it pertains to aggregate supply and aggregate demand■■

Explain the sacrifice ratio■■

Explain why more than rational expectations are needed to reduce inflation without ■■

cost

Key TermsMisery index■■ —The sum of inflation and unemployment

Phillips curve■■ —The short-run trade-off between inflation and unemployment

Natural rate of unemployment■■ —The normal rate of unemployment toward which the economy gravitates

Natural-rate hypothesis■■ —The theory that unemployment returns to its natural rate, regardless of inflation

Disinflation■■ —A reduction in the rate of inflation

Supply shock■■ —An event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and, thus, the Phillips curve

Sacrifice ratio■■ —The number of percentage points of annual output that is lost in order to reduce inflation one percentage point

Rational expectations■■ —The theory that suggests that people optimally use all available information, including about government policies, when forecasting the future

Chapter Overview

Context and PurposeChapter 35 is the final chapter in a three-chapter sequence on the economy’s short-run fluctuations around its long-term trend. Chapter 33 introduced aggregate supply and aggregate demand. Chapter 34 developed how monetary and fiscal policy affect aggregate demand. Both Chapters 33 and 34 addressed the relationship between the price level and output. Chapter 35 will concentrate on a similar relationship between inflation and unemployment.

The purpose of Chapter 35 is to trace the history of economists’ thinking about the relationship between inflation and unemployment. You will see why there is a temporary trade-off between inflation and unemployment and why there is no permanent trade-off. This result is an extension of the results produced by the model of aggregate supply and aggregate demand where a change in the price level induced by a change in aggregate demand temporarily alters output but has no permanent impact on output.

Chapter ReviewIntroduction Since both inflation and unemployment are undesirable, the sum of inflation and unemployment has been termed the misery index. Inflation and unemployment are independent in the long run because unemployment is determined by features of the labor market while inflation is determined by money growth. However, in the short run, inflation and unemployment are related because an increase in aggregate demand

Chapter 35 the short-run trade-off between inflation and unemPloyment 357

temporarily increases infl ation and output while it lowers unemployment. In this chapter, we trace the history of our understanding of the relationship between unemployment and infl ation.

The Phillips CurveIn 1958, a British economist named A. W. Phillips found a negative relationship between infl ation and unemployment. That is, years of high infl ation are associated with low unemployment. This negative relationship has been found for other countries, including the United States, and has been termed the Phillips curve. The Phillips curve appears to off er policymakers a menu of infl ation and unemployment choices. To have lower unem-ployment, one need only choose a higher rate of infl ation.

The model of aggregate supply and aggregate demand can explain the relationship described by the Phillips curve. The Phillips curve shows the combinations of infl ation and unemployment that arise in the short run as shifts in the aggregate-demand curve move along a short-run aggregate-supply curve. For example, an increase in aggregate demand moves the economy along a short-run aggregate-supply curve to a higher price level, a higher level of output, and a lower level of unem ployment. Since prices in the previous period are now fi xed, a higher price level in the current period implies a higher rate of infl ation, which is now associated with a lower rate of unemployment. This can be seen in Exhibit 1. An increase in aggregate demand, which moves the economy from point A to point B in panel (a), is associated with a movement along the short-run Phillips curve from point A to point B.

Shifts in the Phillips Curve: The Role of ExpectationsIn 1968, U.S. economists Friedman and Phelps argued that the Phillips curve is not a menu policy makers can exploit. This is because, in the long run, money is neutral and has no real eff ects. Money growth just causes proportional changes in prices and incomes and should have no impact on un employment. Therefore, the long-run Phillips curve should be vertical at the natural rate of unemploy ment—the rate of unemployment to which the economy naturally gravitates.

A vertical long-run Phillips curve corresponds to a vertical long-run aggregate-supply curve. As Exhibit 1 illustrates, in the long run, an increase in the money supply shifts aggregate demand to the right and moves the economy from point A to point C in panel (a). The corresponding Phillips curve is found in panel (b) where an increase in money

Pri

ce L

evel

Natural Rate of Output

AD2

AD1

Long-runAggregate Supply

B

C

A

Shor t-r un Aggregate

Supply

Quantity of Output

Infla

tio

n R

ate

Natural Rate of

Unemployment

Shor t-r un Phillips Curve

B

C

A

UnemploymentRate

Long-runPhillips Curve

P anel (a) Panel (b)

E X H I B I T 1


growth increases infl ation, but because money is neutral in the long run, prices and incomes move together and infl ation fails to aff ect unemployment. Thus, the economy moves from point A to point C in panel (b) and traces out the long-run Phillips curve.

Friedman and Phelps used the phrase “natural” rate of unemployment, not because it is either desirable or constant, but because it is beyond the infl uence of monetary policy. Changes in labor market policies such as changes in minimum-wage laws and unemployment insurance that lower the natural rate of unemployment shift the long-run Phillips curve to the left and the long-run ag gregate-supply curve to the right.

Even though Friedman and Phelps argued that the long-run Phillips curve is vertical, they argued that, in the short run, infl ation could have a substantial impact on unemployment. Their reasoning is similar to that surrounding the short-run aggregate-supply curve in that they assume, in the short run, price expectations are fi xed. If price expectations are fi xed in the short run, an increase in aggre gate demand causes infl ation, temporarily increases output, and lowers unemployment below the natural rate. For example, according to the sticky-wage theory of short-run aggregate supply, nomi nal wages are set based on fi xed price expectations. When actual prices exceed expected prices, fi rms are more profi table, they expand output and employment, and unemployment is reduced. In Exhibit 2, this is a movement from point A to point B. However, in the long run, people adjust to the higher rate of infl ation by raising their expectations of infl ation (and demanding higher wages) and the short-run Phillips curve shifts upward. The economy moves from point B to point C with higher infl ation but no change in unemployment. Thus, policymakers face a short-run trade-off between infl ation and unemploy ment, but if they attempt to exploit it, the relationship disappears and they arrive back on the vertical long-run Phillips curve at the natural rate of unemployment but at a higher rate of infl ation.

The analysis of Friedman and Phelps can be summarized by the following equation:

Unemployment Rate

= Natural Rate of Unemployment

– a( Actual

Infl ation –

Expected Infl ation )

This says that for any given expected infl ation rate, if actual infl ation exceeds expected infl ation, unemployment will fall below the natural rate by an amount that depends on the parameter a. How ever, in the long run, people learn to expect the infl ation that actually exists, and the unemployment rate will equal the natural rate.

Friedman and Phelps proposed the natural-rate hypothesis, which states that unemployment eventually returns to its natural rate, regardless of infl ation. While controversial, it proved to be true. During the 1960s, expansionary monetary and fi scal

Infla

tio

n R

ate

UnemploymentRate

Long- ru n Phillips Curve

Shor t-r un Phillips Curve withhigh expected inflation

Shor t-r un Phillips Curve withlow expected inflation

A

B C

Natural Rate of Unemployment

E X H I B I T 2


policies steadily increased the rate of infl ation and unemployment fell. However, in the early 1970s, people raised their expectations of infl ation and the unemployment rate returned to the natural rate—about 5 or 6 percent.

Shifts in the Phillips Curve: The Role of Supply ShocksThe short-run Phillips curve can also shift due to a supply shock. A supply shock is an event that directly alters fi rms’ costs and prices, shifting the economy’s aggregate-supply curve and Phillips curve. A supply shock occurred in 1974 when OPEC raised oil prices. This act raised the cost of production and shifted the U.S. short-run aggregate-supply curve to the left, causing prices to rise and output to fall, or stagfl ation. Since infl ation has increased and unemployment has increased, this corresponds to a rightward (upward) shift in the short-run Phillips curve. Policymakers now face a less favorable trade-off between infl ation and unemployment. That is, policymakers must accept a higher infl ation rate for each unemployment rate, or a higher unemployment rate for each infl a tion rate. Also, policymakers now have a diffi cult choice because if they reduce aggregate demand to fi ght infl ation, they will further increase unemployment. If they increase aggregate demand to reduce unemployment, they further increase infl ation.

If the supply shock raises expected infl ation, the Phillips-curve shift is “permanent.” If it does not raise expected infl ation, the shift is temporary. In the United States during the 1970s, the Fed accom modated two adverse aggregate supply shocks by increasing aggregate demand to keep output from falling. This caused expected infl ation to rise, and the rightward (upward) shift in the Phillips curve was “permanent.” By 1980, infl ation was 9 percent and unemployment was 7 percent.

Some argue that in 2008 the Fed is not exerting its independence and is instead repeating the mistakes of the 1970s by accommodating a negative supply shock.

The Cost of Reducing Infl ationIn October 1979, Fed Chairman Paul Volcker chose to pursue a policy of disinfl ation—a reduction in the rate of infl ation. A reduction in the money supply reduces aggregate demand, reduces pro duction, and increases unemployment. This is shown in Exhibit 3 as a movement from point A to point B. Over time, expected infl ation falls and the short-run Phillips curve shifts downward and the economy moves from point B to point C.

The cost of reducing infl ation is a period of unemployment and lost output. The sacrifi ce ratio is the number of percentage points of annual output that is lost to reduce

Infla

tio

n R

ate

UnemploymentRate

Long-runPhillips Curve

Shor t-r un Phillips Curve withhigh expected inflation

Shor t-r un Phillips Curve withlow expected inflation

C B

A

Natural Rate of Unemployment

E X H I B I T 3


inflation one percentage point. The amount of output lost depends on the slope of the Phillips curve and how fast people lower their expectations of inflation.

Some economists estimated the sacrifice ratio to be about five, which is very large. Supporters of a theory called rational expectations suggested that the cost of disinflation could be much smaller and may be zero. Rational expectations suggest that people optimally use all available information, including information about government policies, when forecasting the future. Thus, an announced policy of disinflation that is credible could move the economy from point A to point C without travel ing through point B. Volcker announced a disinflationary policy in late 1979 and reduced inflation from 10 percent to 4 percent by 1984 but at the cost of a substantial increase in unemployment. Note, however, that the increase in unemployment was less than that predicted by the estimated sacrifice ratio. The rational expectations theory may not be accurate, or people may not have believed the policy announcement.

Monetary policy under Alan Greenspan did not repeat the mistakes of the 1960s when excessive aggregate demand pushed unemployment below the natural rate. The low inflation and low unemployment of the Greenspan era were the result of a favorable supply shock and prudent monetary policy.

Bernanke faces the following economic challenges: A housing market bust and financial crisis that reduced aggregate demand, and rising oil and commodity prices that reduced aggregate supply. Thus, the economy faces rising unemployment and rising inflation. Bernanke hopes to keep inflation expectations low so that workers won’t increase wage demands and firms won’t increase prices.

Helpful Hints

1. Short-run and long-run Phillips curves are almost a mirror image of short-run and long-run aggregate-supply curves. Look at the supply curves that appear in Exhibit 1. Notice the aggre gate-supply curves in panel (a). Compare them to the Phillips curves in panel (b). They appear to be mirror images of each other. The long-run aggregate-supply curve is vertical because, in the long run, an increase in the price level is met by a proportionate increase in all prices and incomes so there is no incentive to alter production. Since an increase in prices has no effect on output in the long run, it has no effect on unemployment, and the long-run Phillips curve is vertical in panel (b). In the short run with price expectations fixed, an increase in the price level provides an incentive for firms to increase production, causing the short-run aggregate-supply curve to be positively sloped in panel (a). When output rises, unemployment tends to fall, so the short-run Phillips curve is negatively sloped in panel (b). In summary, since both graphs employ some measure of prices on the vertical axis, and since each graph uses real measures of economic activity that are negatively correlated on their respective horizontal axes (an increase in output is associated with a decrease in unemployment), then aggregate-supply curves and Phillips curves should “mirror” each other.

2. To understand the short-run Phillips curve, review short-run aggregate supply. To gain confi dence deriving and shifting short-run Phillips curves, review the sources to the positive slope of the short-run aggregate-supply curve in Chapter 33. There you will be reminded that there are a number of reasons why a short-run aggregate-supply curve slopes positively—misperceptions about relative price, sticky wages, and sticky prices. Since short-run aggregate-supply curves and Phillips curves are mirror


images of each other, the very same reasons that produce a posi tive slope in aggregate supply produce a negative slope in the Phillips curve. Also, recall that all three theories of the short-run aggregate-supply curve are based on the assumption of fixed price expectations. When price expectations rise, the short-run aggregate-supply curve shifts left. Correspondingly, since the short-run aggregate-supply curve and the Phillips curve are mirror images, a rise in price expectations shifts the Phillips curve to the right.

3. The Phillips curve establishes a relationship between inflation and unemployment, but it does not establish causation. Reading the Phillips curve from the unemployment axis to the inflation axis suggests that when unemployment is unusually low, the labor market is tight and wages and prices start to rise more quickly.

4. Estimates of the natural rate of unemployment vary widely, causing policymakers to disagree on the appropriate monetary and fiscal policies. When looking at a Phillips curve graph or the model of aggregate supply and aggregate demand, it appears as if policymakers should always know whether to expand or contract aggregate demand or whether to leave aggregate demand alone. This is because we can see whether the economy is operating above or below the long-run natural rate that we have chosen on the graph. In reality, however, the natural rate is very difficult to measure and policymakers are uncertain whether the economy is actually operating above or below the natural rate. For example, if the economy is currently operating at 6 percent unemployment, the economy is operating below capacity if the natural rate of unemployment is 5 percent, at capacity if the natural rate is 6 percent, and above capacity if the natural rate is 7 percent. Each situation might suggest a different stabilization policy, even though the actual rate of unemployment is unchanged at 6 percent.

Self-Test

Multiple-Choice Questions

1. In the short runa. unemployment and inflation are positively related. In the long run, they are

largely unrelated problems.b. and in the long run, inflation and unemployment are positively related.c. unemployment and inflation are negatively related. In the long run, they are

largely unrelated problems.d. and in the long run, inflation and unemployment are negatively related.e. unemployment and inflation are negatively related. In the long run, they are

largely positively related.


Figure 35-1

The left-hand graph shows a short-run aggregate-supply (SRAS) curve and two aggregate-demand (AD) curves. On the right-hand diagram, U represents the unemployment rate.

P

SRAS

High AD

Phillips Curve

Low AD

130

30

15

6% 10%

115

A B

D

F

G

U

C

2. Refer to Figure 35-1. If the economy starts at B, then in the short run, a decrease in consumer confidence that decreases spending moves the economy toa. D and G.b. C and G.c. A and G.d. D and F.e. C and F.

3. Refer to Figure 35-1. Starting at point C, which combination of points would be correct for an economy that experienced a decrease in unemployment and a price level increase?a. D and Gb. D and Fc. A and Fd. A and Ge. B and F

4. In 2001, Congress and President Bush instituted tax cuts. According to the short-run Phillips curve, in the short run this change should havea. reduced inflation and unemployment.b. raised inflation and unemployment.c. reduced inflation and raised unemployment.d. raised inflation and reduced unemployment.e. reduced unemployment and left unemployment unchanged.

5. The current view of the Phillip’s curve relationship is thata. the trade-off between inflation and unemployment does not apply in the long run.b. the trade-off between inflation and unemployment does not apply in the short run.c. the trade-off between inflation and unemployment does not apply in either the

short run or the long run.d. the trade-off between inflation and unemployment applies both in the short run

and the long run.e. the trade-off between inflation and unemployment applies only in the long run

as in the short run there is no trade-off.

6. How would a decrease in the natural rate of unemployment affect the long-run Phillips curve?a. It would shift the long-run Phillips curve right.b. It would shift the long-run Phillips curve left.c. There would be an upward movement along a given long-run Phillips curve.d. There would be a downward movement along a given long-run Philips curve.e. There would be no effect on the long-run Phillips curve.


Figure 35-2

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1 2 3 4 5 6 7 8 9 10

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10

UnemploymentRate

Infla

tion

Rate

A B

C

D

7. Refer to figure 35-2. In this order, which curve is a long-run Phillips curve and which is a short-run Phillips curve?a. A, Bb. A, Dc. C, Bd. D, Ae. A, C

8. An adverse supply shock will have which of the following combinations of events? Aggregate Supply Price Level Real Output

A. shift right increase increaseB. shift right increase decreaseC. shift right decrease decreaseD. shift left increase increaseE. shift left increase decreasea. Ab. Bc. Cd. De. E

9. An adverse supply shock causes inflation toa. rise and the short-run Phillips curve to shift right.b. rise and the short-run Phillips curve to shift left.c. fall and the short-run Phillips curve to shift right.d. fall and the short-run Phillips curve to shift left.e. fall and the long-run Phillips curve to shift right.

10. Suppose that a small economy that produces mostly agricultural goods experiences a year with exceptionally good conditions for growing crops. The good weather woulda. shift both the short-run aggregate supply and the short-run Phillips curve right.b. shift both the short-run aggregate supply and the short-run Phillips curve left.c. shift the short-run aggregate supply curve to the right, and the short-run Phillips

curve to the left.d. shift the short-run aggregate supply curve to the left, and the short-run Phillips

curve to the right.e. shift the short-run aggregate supply curve to the right, and cause a movement

along the existing Phillips curve downward and to the right.


11. Disinflation is defined as aa. zero rate of inflation.b. constant rate of inflation.c. reduction in the rate of inflation.d. negative rate of inflation.e. high rate of inflation.

12. During the middle and last part of the 1990s, both inflation and unemployment were low. In general, this could have been the result ofa. adverse supply shocks that shifted the short-run Phillips curve left.b. adverse supply shocks that shifted the short-run Phillips curve right.c. favorable supply shocks that shifted the short-run Phillips curve left.d. favorable supply shocks that shifted the short-run Phillips curve right.e. favorable supply shocks that shifted the long-run Phillips curve right.

Free Response Questions

1. In the long run, what primarily determines the natural rate of unemployment? In the long run, what primarily determines the inflation rate?

2. Suppose that the prime minister and parliament of Veridian are disappointed with the high inflation rates under the current system where the Veridian Ministry of Finance is in charge of the money supply. They make reforms to lower inflation from its current rate of 8 percent. Suppose further that the public is confident that with the reforms in place that inflation will fall to 2 percent. Also suppose that those in control of the money supply actually conduct monetary policy so that the actual inflation rate is 4 percent. Using long-run and short-run Phillips curves and assuming the natural rate of unemployment is 6 percent, show the initial long-run equilibrium of Veridian and label it “A.” Assuming that the government had actually set inflation at 2 percent and that the public believed this, label the long-run equilibrium “B.” Now, suppose that inflation expectations fell to 2 percent and that the government unexpectedly created inflation of 4 percent. Show the short-run equilibrium and label it “C.” If the money supply continues to grow at a rate consistent with 4 percent inflation, show where the economy ends up and label that point “D.”


SolutionsMultiple-Choice Questions 1. c TOP: Phillips curve 2. b TOP: Aggregate demand and supply | Short-run Phillips curve 3. e TOP: Expansionary policy 4. d TOP: Short-run Phillips curve 5. a TOP: Phillips curve 6. b TOP: Long-run Phillips curve | Natural rate of unemployment 7. b TOP: Short-run Phillips curve | Long-run Phillips curve 8. e TOP: Supply shocks 9. a TOP: Short-run Phillips curve shifts | Supply shocks 10. c TOP: Short-run Phillips curve shifts | Supply shocks 11. c TOP: Disinflation 12. c TOP: Supply shocks | Short-run Phillips curve shifts

Free Response Questions 1. In the long run, the natural rate of unemployment is primarily determined by labor market factors, including

government policy concerning minimum wages and unemployment benefits. In the long run, inflation is primarily determined by money supply growth.

TOP: Inflation | Natural rate of unemployment | Classical dichotomy

2. A correctly drawn Phillips curve will have inflation on the vertical axis and unemployment on the horizontal axis. The initial long-run equilibrium would be drawn at A where the vertical long-run Phillips curve intersects the short-run Phillips curve at an inflation rate of 8 percent. The new long-run and short-run equilibrium created when the government set inflation at 2 percent and the public believed this would happen is shown by point B. If the government unexpectedly created an inflation of 4 percent, there would be a movement along a short-run Phillips curve to point C. If the money supply grows at a rate consistent with a 4 percent inflation rate, a new long-run equilibrium would be established at point D.

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Infla

tion

Rate

UnemploymentRate

Veridian Phillips Curves

A

D

B

C

TOP: Short-run Phillips curve shifts | Long-run Phillips curve

chapter 35

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