Unemployment, Inflation and the Phillips Curve

A comprehensive set of question-and-answer flashcards covering the twin evils of macroeconomics, evolution of the Phillips curve, expectations-augmented theory, policy debates, the natural rate of unemployment, the costs of unemployment, and the concept of the sacrifice ratio.

What are the "twin evils" of macroeconomics?

Unemployment and inflation.

Who first documented a statistical trade-off between unemployment and nominal wage growth?

A. W. Phillips in 1958.

What empirical relationship is known as the Phillips curve?

The historical negative relationship between unemployment and inflation (or wage growth).

During which U.S. decade did inflation rise while unemployment fell along an apparent Phillips curve?

The 1960s.

What economic phenomenon in the mid-1970s contradicted the simple Phillips curve?

Stagflation—simultaneously high inflation and high unemployment.

What three questions did the collapse of the Phillips curve after 1970 raise?

(1) Why had the curve appeared historically? (2) Why did it vanish after 1970? (3) Does it provide a usable policy menu of inflation-unemployment choices?

Which two Nobel laureates developed the expectations-augmented Phillips curve?

Milton Friedman and Edmund Phelps.

According to Friedman and Phelps, which two variables have a negative relationship?

Unanticipated inflation and cyclical unemployment.

Define unanticipated inflation in one sentence.

The difference between actual inflation and expected inflation.

Define cyclical unemployment in one sentence.

The difference between the actual unemployment rate and the natural rate of unemployment.

In the extended classical model, what happens if money supply growth is fully anticipated?

Unanticipated inflation is zero, and unemployment stays at the natural rate.

What causes output to rise above full employment in the misperceptions theory?

A higher-than-expected price level (positive unanticipated inflation) that fools producers about relative prices.

Write the expectations-augmented Phillips curve equation.

π = π^e − h(u − u^n) where π is actual inflation, π^e expected inflation, u actual unemployment, u^n natural unemployment, and h>0.

If actual unemployment equals the natural rate, how does actual inflation compare with expected inflation?

They are equal; unanticipated inflation is zero.

Name three factors that can shift the Phillips curve.

(1) Changes in expected inflation, (2) changes in the natural unemployment rate, (3) supply shocks.

How does an adverse supply shock shift the Phillips curve?

Upward and to the right (higher inflation for any given unemployment).

Why did the traditional Phillips curve disappear after 1970 in the United States?

Because expected inflation and the natural unemployment rate began to vary considerably, partly due to oil-price shocks.

Despite instability in the inflation-unemployment data, what relationship held from 1970-2005?

A negative relationship between unanticipated inflation and cyclical unemployment.

According to classical economists, can policymakers systematically exploit the Phillips curve?

No; rapid wage-price adjustments and rational expectations prevent sustained unanticipated inflation.

Why do Keynesians think short-run exploitation of the Phillips curve is possible?

Price stickiness means some prices are based on outdated information, allowing temporary unanticipated inflation to lower unemployment.

What does the long-run Phillips curve look like and why?

A vertical line at the natural unemployment rate because expected and actual inflation eventually equalize.

State Okun’s law in words.

Each percentage point of cyclical unemployment is associated with roughly a 2 % loss of full-employment output.

List the two principal costs of unemployment.

(1) Lost output/income, (2) psychological and social costs to workers and families.

Why might frictional unemployment impose little net economic cost?

Time spent job-searching can lead to better matches and higher future productivity.

What demographic trend helped raise the U.S. natural unemployment rate in the 1960s-70s?

Greater labor-force participation by women and teenagers (groups with higher unemployment rates).

Which demographic change since 1980 helped reduce the natural unemployment rate?

A declining share of young workers (ages 16–24) in the labor force.

Give two possible reasons the U.S. natural rate may have fallen in the late 1990s.

(1) More efficient job matching (e.g., temp agencies, internet job sites). (2) A productivity surge outpacing wage aspirations.

Why is measuring the natural rate of unemployment difficult for policymakers?

It cannot be directly observed; estimates contain significant uncertainty.

Define the sacrifice ratio.

The percentage of one year’s potential output lost for each one-percentage-point reduction in inflation.

What was the estimated sacrifice ratio for the early-1980s U.S. disinflation?

About 1.83 (i.e., 1.832 % of potential GDP lost per 1 % drop in inflation).

How does labor-market flexibility affect a country’s sacrifice ratio?

More rigid wage adjustment tends to raise the sacrifice ratio.

Do rapid or gradual disinflations usually have lower sacrifice ratios according to Ball’s study?

Rapid ("cold-turkey") disinflations.

Give one caveat when interpreting estimated sacrifice ratios.

It is hard to separate output losses due solely to disinflation from those caused by other shocks.

What policy implication follows if unemployment is above the natural rate?

Expansionary monetary or fiscal policy may be used to shift aggregate demand rightward toward full-employment output.

How does the expectations-augmented Phillips curve inform policy about long-run unemployment?

In the long run, no level of sustained inflation can keep unemployment below the natural rate.

Under rational expectations, why can’t governments keep creating unanticipated inflation indefinitely?

Economic agents learn the pattern, adjust expectations, and eliminate the surprise element.

What is stagflation, and why is it inconsistent with the original Phillips curve?

Simultaneous high inflation and high unemployment; the original Phillips curve predicted they should move in opposite directions.

Explain how supply shocks affect both expected inflation and the natural rate.

They raise production costs, boosting expected inflation, and may disrupt labor markets, increasing the natural unemployment rate.

What does a vertical long-run Phillips curve imply about the inflation-unemployment trade-off?

There is no permanent trade-off; unemployment returns to the natural rate regardless of inflation.

Why might policymakers choose gradual rather than rapid disinflation despite evidence on sacrifice ratios?

Concerns about political feasibility, distributional impacts, and uncertainty over true sacrifice ratios.

State one reason high unemployment persists during tight anti-inflation policies even under rational expectations.

Sticky wages and prices delay the full adjustment to lower aggregate demand.

How does Okun’s law translate a 1 % cyclical unemployment rise into output loss if potential GDP is $10 trillion?

Approximately $200 billion (2 % of potential GDP).

What key lesson does the expectations-augmented Phillips curve teach about credible policy?

Credibility that anchors expected inflation reduces unanticipated inflation and its real economic effects.

In Ball’s cross-country study, which nation had the highest average sacrifice ratio and why?

Germany (~3.0) due partly to slower wage adjustments and rigid labor regulations.