(Chapter 17) The Trade-Off Between Inflation and Unemployment

Demand-side inflation

-A rise in the price level caused by rapid growth of aggregate demand

-Accompanied by rapid growth of GDP

Supply-side inflation

-A rise in the price level caused by slow growth (or decline) of aggregate supply

-Accompanied by stagnant or even falling GDP

What if fluctuations in economic activity are caused primarily by the AD curve?

If fluctuations in economic activity are caused primarily by variations in the rate at which the aggregate demand curve shifts outward from year to year, then the data should show an inverse relationship between unemployment and inflation.

Phillips curve

A graph depicting the rate of unemployment on the horizontal axis and either the rate of inflation or the rate of change of money wages on the vertical axis. Phillips curves are normally downward sloping, indicating that higher inflation rates are associated with lower unemployment rates.

What if fluctuations in economic activity emanate from the supply side?

Higher rates of inflation will be associated with higher rates of unemployment, and lower rates of inflation will be associated with lower rates of unemployment.

How do shifts in aggregate demand affect the Phillips curve?

-Increase in demand = upward (leftward) movement along the Phillips curve.

-Decrease in demand = downward (rightward) movement along the Phillips curve.

How do shifts in aggregate supply affect the Phillips curve?

-If AS increases = Phillips curve shifts left (down)

-If AS decreases = Phillips curve shifts right (up)

How does the economy's self-correction mechanism show on the Phillips curve?

On a Phillips curve diagram, neither points corresponding to an inflationary gap nor points corresponding to a recessionary gap can be maintained indefinitely. Inflationary gaps lead to rising unemployment and rising inflation. Recessionary gaps lead to falling inflation and falling unemployment.

Natural rate of unemployment

The economy's self correcting mechanism always tends to push the unemployment rate back toward a specific rate of unemployment that we call this.

Vertical Long-Run Phillips Curve

Shows the menu of inflation/unemployment choices available to society in the long run. It is a vertical straight line at the natural rate of unemployment.

The Trade-Off Between Inflation and Unemployment

-In the short run, it is possible to "ride up the Phillips curve" toward lower levels of unemployment by stimulating aggregate demand. Conversely, by restricting the growth of demand, it is possible to "ride down the Phillips curve" toward lower rates of inflation. Thus, there is a short-run trade-off between unemployment and inflation. Stimulating demand will improve the unemployment picture but worsen inflation; restricting demand will lower inflation but aggravate the unemployment problem.

-However, there is no such trade-off in the long-run. The economy's self-correcting mechanism ensures that unemployment will eventually return to the natural rate no matter what happens to aggregate demand. In the long-run, faster growth of demand leads only to higher inflation, not to lower employment; and slower growth of demand leads only to lower inflation, not to higher unemployment.

The cost of expansionary fiscal and monetary policy

-Cost of reducing unemployment more rapidly by expansionary fiscal and monetary policies is a permanently higher inflation rate (movement left along the short-run Phillips curve to the long-run curve).

-Because is self-correction was allowed, a supply movement to the right would lead to lower inflation in the long run (a point lower than the one achieved through expansionary policy)

What should be done? Should the government pay the inflationary costs of fighting unemployment?

-Depends on how one views the costs of inflation compared to the costs of unemployment.

-The slope of the short-run Phillips curve matters. The steeper the curve, the higher the inflationary costs of using expansionary policy to lower unemployment.

-The efficiency of the economy's self-correcting mechanism also makes a difference. The faster wage changes push the supply curve back to full employment, the les suffering there will be. The slower they change, the more suffering there will be as the recessionary gap lingers for a longer time. Most economists believe it is rather inefficient.

What if workers see inflation coming?

-If workers can see inflation coming, and if they receive compensation for it, inflation does not erode real wages. But if real wages do not fall, firms have no incentives to increase production. In such a case, the economy's aggregate supply curve will not slope upward but, rather, will be a vertical line at the level of output corresponding to potential GDP.

-The vertical short-run Phillips curve will also be a vertical line.

When is the supply curve upward sloping?

The short-run aggregate supply curve is vertical when inflation is predicted accurately but upward sloping when inflation is underestimated. Thus, only unexpectedly high inflation will raise output, because only unexpected inflation reduces real wages. Similarly, only an unexpected decline in inflation will lead to a recession.

Why is the short-run Phillips curve sloping?

We assume that workers underestimate inflation when it is rising and overestimate it when it is falling.

Rational expectations

-Forecasts that, although not necessarily correct, are the best that can be made given the available data. Rational expectations, therefore, cannot err systematically. If expectations are rational, forecasting errors are pure random numbers.

-Inflation - Expected Inflation = A random number

-If expectations are rational, inflation can be reduced without a period of high unemployment because the short-run Phillips curve, like the long-run Phillips curve, will be vertical.

-Workers will not make systematic errors. Forecasts will sometimes be too high and sometimes too low.

Reasons why the rational expectations theory is wrong

Economists believe that there is a tradeoff between inflation and unemployment in the short run for these reasons:

-Old contracts may embody outdated expectations

-Expectations may adjust slowly

-Most economists argue that wages catch up to actual inflation after the fact

-It suggests that unemployment should hover around the natural rate most of the time and that anti-inflationary programs should be relatively painless. But these are obviously incorrect.

The dilemma of demand management

Even though AS curve movements will destroy the statistical Phillips curve relationship, monetary and fiscal policies will make unemployment and inflation move in opposite directions since they deal with AD. No matter what, monetary and fiscal policy authorities will still face a trade-off between inflation and unemployment.

Attempts to improve the trade-off

-Retraining programs and employment services. However, the US government has enjoyed only modest success with these measures

-Indexing to attempt to reduce the social costs of inflation. Opponents of it worry that the economy's resistance to inflation may be lowered by indexing.

Indexing

Refers to provisions in a law or a contract whereby monetary payments are automatically adjusted whenever a specified price index changes. Wage rates, pensions, interest payments on bonds, income taxes, and money other things can be indexed in this way, and have been. Sometimes called escalator clauses.