Chapter 17 Summary Notes: The Short-Run Tradeoff Between Inflation and Unemployment (Phillips Curve, Expectations, Supply Shocks, and Disinflation)

17-1 The Phillips Curve

  • Two closely watched indicators of economic performance: inflation and unemployment. Policymakers care about both; some commentators use the misery index (inflation + unemployment).
  • Long-run relationships:
    • Natural rate of unemployment depends on labour-market features (minimum wages, EI generosity, unions’ market power, efficiency wages, job search effectiveness).
    • Inflation depends mainly on money growth controlled by the central bank.
    • In the long run, inflation and unemployment are largely unrelated.
  • Short-run relationship (the trade-off):
    • One of the 10 principles: a short-run trade-off between inflation and unemployment exists.
    • If policymakers expand aggregate demand (AD↑) and move up along the short-run aggregate-supply (SRAS) curve, unemployment falls temporarily but inflation rises.
    • If policymakers contract AD to move down along SRAS, inflation falls but unemployment rises temporarily.
  • History and significance:
    • The Phillips curve captures the short-run trade-off; its development connected data from the UK, North America, and Western Europe.
    • Samuelson and Solow argued that policy could choose points along the curve via monetary and fiscal policy (a menu of outcomes).
  • The basic AD–AS explanation of the Phillips curve:
    • An increase in AD raises output and price level in the short run.
    • Higher output lowers unemployment; higher price level implies higher inflation.
    • Hence, AD shifts move the economy to points with lower unemployment but higher inflation (and vice versa).
  • Example (illustrative numbers, 2020–2021 style):
    • Assume price level P2020 = 100.
    • If AD is relatively low (point A): output = 7500, price level = 102 → inflation ≈ 2%; unemployment high (e.g., 7%).
    • If AD is relatively high (point B): output = 8000, price level = 106 → inflation ≈ 6%; unemployment low (e.g., 4%).
    • Phillips curve interpretation: A has higher unemployment, lower inflation; B has lower unemployment, higher inflation.
  • Policy takeaway:
    • Monetary and fiscal policy can move the economy along the Phillips curve by shifting AD, trading off inflation against unemployment in the short run.
  • Quick Quiz (conceptual): Draw the Phillips curve and show on AD–AS how policy can move the economy from a high-inflation/low-unemployment point to a lower-inflation point along the curve.

17-2 Shifts in the Phillips Curve: The Role of Expectations

  • The question: Is the downward-sloping Phillips curve stable over time? Do we have a permanent trade-off?
  • 17-2a The Long-Run Phillips Curve (LRPC):
    • Friedman (1968) and Phelps argued there is no long-run trade-off; monetary policy cannot permanently reduce unemployment below its natural rate.
    • In the long run, money growth determines inflation, not unemployment.
    • The LRPC is vertical at the natural rate of unemployment (u*).
    • Visualization link: vertical LRPC aligns with a vertical long-run aggregate-supply (LRAS) curve; monetary policy affects nominal variables (price level, inflation) but not real variables (output, unemployment) in the long run.
  • 17-2b The Meaning of “Natural”
    • Natural rate is the level toward which unemployment gravitates in the long run, not necessarily socially desirable.
    • It can change with policy and institutions (e.g., stronger unions, higher real wages, job-search frictions).
    • Monetary expansion cannot permanently reduce the natural rate; it would only raise inflation.
    • Other policies (labor-market reforms) can alter the natural rate and shift the LRPC left or right.
  • 17-2c Reconciling Theory and Evidence
    • Phillips–Lipsey observations were empirical, not just theoretical.
    • Friedman–Phelps reconciled: short-run trade-off may exist, but not in the long run; expectations matter.
    • The role of expectations: rational expectations and the Keynesian view both influence interpretation.
    • The short-run trade-off depends on expected inflation; if people expect higher inflation, the short-run curve shifts.
  • 17-2d The Short-Run Phillips Curve (SRPC)
    • Core equation (short-run relationship with expectations):
      u = u^* - a(\
      u - \pi^e)
      where u is the unemployment rate, u* is the natural rate, \nu is actual inflation, and \pi^e is expected inflation, and a > 0 measures the responsiveness (slope depends on the SRAS slope).
    • In the short run, with given expected inflation, higher actual inflation lowers unemployment (the trade-off).
    • In the long run, as people adjust to the actual inflation, actual inflation = expected inflation and unemployment returns to the natural rate; the SRPC shifts as expectations adjust.
    • The intersection of the SRPC with the LRPC occurs at the expected rate of inflation.
    • Shifts in expected inflation move the entire SRPC (not a simple rotation): higher expected inflation shifts SRPC to the right; lower expected inflation shifts it left.
    • Caution for policymakers: focusing on the Phillips curve as a menu of permanent options is dangerous because expectations adjust.
    • Illustration: start at point A (low expected inflation, u = u). Expansionary policy to reduce unemployment moves to point B (unemployment below u, inflation higher). Over time, expectations adjust and the economy moves toward point C (higher inflation, unemployment back to u*).
  • 17-2e The Natural Experiment for the Natural-Rate Hypothesis
    • Canadian and U.S. data from 1956–1968 showed a Phillips curve (negative inflation–unemployment relationship).
    • 1969–1973: monetary/fiscal expansion raised inflation, without a lasting unemployment reduction; unemployment rose to ~7%+ and inflation remained high in the early 1970s, consistent with expectations catching up.
    • The 1970s oil-price shocks and stagflation (1973–1975) demonstrated the failure of the simple downward-sloping Phillips curve; expectations adjusted and the trade-off deteriorated.
    • The breakdown around 1970–73 supported the idea that there is no stable long-run trade-off; the curve shifted due to changes in expected inflation.
  • 17-3 Shifts in the Phillips Curve: The Role of Supply Shocks
    • Supply shocks (e.g., OPEC oil price shocks in the 1970s) shift the SRPC itself, not just the AD; these are adverse supply shocks.
    • Mechanism: higher input costs reduce output (AS shifts left), raise the price level (inflation), and raise unemployment (unemployment rises).
    • Result: the short-run trade-off becomes less favorable; the SRPC shifts to the right (from PC1 to PC2).
    • Policy dilemma: contractionary demand policy to fight inflation worsens unemployment; expansionary policy to fight unemployment worsens inflation.
    • The persistence of higher inflation depends on whether the supply shock is viewed as temporary or permanent; if viewed as permanent, expected inflation rises and the SRPC remains shifted.
    • Real-world example: 1970s Canada experienced OPEC shocks and stagflation; policy responses included tight monetary policy and wage/price controls; inflation fell but unemployment rose; inflation expectations adjusted slowly; by the end of the decade, inflation remained elevated when oil prices rose again in 1979.
  • 17-4 The Cost of Reducing Inflation
    • In October 1979, Canada pursued disinflation (reduction in the rate of inflation).
    • 17-4a The Sacrifice Ratio
    • Cost of disinflation is measured in terms of lost output during the transition (short-run sacrifice) and is often expressed as the sacrifice ratio: the number of percentage points of one year’s output sacrificed to reduce inflation by 1 percentage point.
    • Typical Canadian estimates ranged from about 2 to 5 in the late 20th century.
    • Example: If inflation is reduced by 6 percentage points, and the sacrifice ratio is 5, then output losses could be around 30% of one year's output; unemployment could rise by about 15 percentage points (via Okun’s law).
    • The mechanism: contractionary monetary policy reduces AD, lowering output and raising unemployment in the short run; over time, as inflation expectations adjust downward, the SRPC shifts downward and unemployment returns to u*.
    • 17-4b Rational Expectations and the Possibility of Costless Disinflation
    • Rational expectations revolution (Lucas, Sargent, Barro) argued that people use all available information about government policy to forecast future inflation.
    • If policymakers credibly commit to low inflation, people adjust expectations quickly, enabling a potentially costless disinflation (
      the short-run Phillips curve would shift down with the fall in expected inflation).
    • In practice, the observed cost of disinflation in the 1980s was sensitive to credibility and the policy regime; forecasts often lagged behind actual outcomes, causing costs to appear higher than the rational-expectations view would suggest.
    • Sargent’s view (1981) emphasizes that the sacrifice ratio could be much smaller or even zero if the government credibly commits to low inflation.
    • 17-4c Disinflation in the 1980s
    • Bank of Canada pursued deep disinflation in the early 1980s; inflation fell from about 10% to around 3% by mid-1980s, but unemployment rose to 10%+ in several years (1983–1985).
    • The observed sacrifice ratio for 1981–1989 was about 2.1 (unemployment rose for several years as inflation fell).
    • Credibility issues: public expectations did not fall as quickly as policy anticipated; forecasts often lagged behind actual inflation reductions.
    • 17-4d The Zero-Inflation Target
    • In 1989, Bank of Canada Governor John Crow announced a zero inflation target; inflation dropped sharply in the early 1990s (1989–1993), but unemployment rose (peaking around 11% in 1993).
    • The target was reached around 1993, and inflation hovered near 1–3% thereafter; unemployment gradually returned toward prior natural-rate levels.
    • 17-4e Anchored Expectations
    • By the late 1990s, inflation expectations appeared anchored around the Bank of Canada’s target (core CPI stabilization between roughly 1–3% and a credible policy regime).
    • Anchored expectations imply that the SRPC remains relatively stable; the long-run Phillips curve remains vertical and policy can focus on inflation targets while unemployment can improve without destabilizing inflation.
    • 17-4f The 2008–09 Recession
    • The financial crisis caused a large fall in aggregate demand, shifting the AD curve left and moving the economy down along the SRAS; inflation fell while unemployment rose above the natural rate.
    • The data show unemployment rising by about 2.5 percentage points and inflation falling in the early recession years; subsequent years saw gradual re-emergence toward pre-crisis inflation levels and unemployment returning toward its natural rate.
  • 17-5 Looking Ahead
    • The 60-year journey shows the temporary nature of the inflation–unemployment trade-off and its instability over time.
    • Reducing inflation can involve substantial sacrifice (unemployment and lost output) if the policy regime is not credible or if external shocks occur.
    • The central takeaway: policy should be careful about short-run trade-offs; preserving credibility and a stable inflation target helps anchor expectations and minimizes necessary sacrifice in the long run.
    • Policy implications:
    • Maintain credible inflation targets and disciplined fiscal policy to avoid large, destabilizing shifts in aggregate demand.
    • Structural reforms to reduce the natural rate of unemployment can improve outcomes in the long run.
    • Be prepared for supply shocks (e.g., energy price shocks) and understand their impact on inflation and unemployment through shifts of the SRPC.
  • 17-6 Conclusion
    • Key economists and ideas summarized: Phillips curve (Phillips, Lipsey, Samuelson, Solow), the natural-rate hypothesis (Friedman, Phelps), and rational expectations (Lucas, Sargent, Barro).
    • The core principle: There is a temporary trade-off between inflation and unemployment, driven by expectations and by shifts in AD, AS, and policy credibility; in the long run the trade-off disappears and unemployment tends toward its natural rate.
    • Milton Friedman’s conclusion (1968): There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off arises from unanticipated inflation, which over time becomes anticipated.
    • The historical lesson emphasizes the importance of credible, disciplined policy and the recognition that the long-run path of the economy depends on expectations, supply conditions, and labor-market policies rather than on monetary policy alone.

Equations and key definitions used in these notes

  • Phillips curve relationship (short run):
    u = u^* - a(\,\pi - \pi^e)
    where u is the unemployment rate, u* is the natural rate of unemployment, \pi is actual inflation, \pi^e is expected inflation, and a > 0.
  • Unemployment and inflation dynamics (long run): monetary policy can affect nominal variables (price level, inflation) but not real variables (output, unemployment) in the long run; thus the long-run Phillips curve is vertical at u = u*
  • Sacrifice ratio (definition): the number of percentage points of one year’s output sacrificed to reduce inflation by 1 percentage point.
    • Typical Canadian estimates: SR ≈ 2 to 5 (Canada, various periods).
  • Okun’s law (illustrative form):
    • A change of 1 percentage point in GDP translates into about a 0.5 percentage-point change in unemployment.
    • Expressed as:
      ext{Δ}U \approx -0.5 \\Delta \%Y
      where ΔU is the change in unemployment (percentage points) and Δ%Y is the percentage-point change in output.
  • Disinflation and the cost in the short run:
    • A period of higher unemployment accompanies a disinflation process as inflation expectations adjust.
    • The cost is borne during the transition until expectations adjust downward and the SRPC shifts.

Key historical anchors and examples mentioned

  • Origins of the Phillips curve (1958): A. W. Phillips found a negative relationship between unemployment and the rate of change in money wages in the UK (1861–1957).
  • Lipsey (early 1960s): quantitative extension of Phillips’s idea.
  • Samuelson and Solow (early 1960s): linked the Phillips curve to policy via aggregate-demand shifts along the AD–SRAS framework.
  • 1960s–1970s data: the trade-off seemed to hold; later, oil-price shocks and evolving expectations challenged the simple view.
  • 1970s–1980s: OPEC oil shocks produced stagflation; the SRPC shifted to the right; credibility and expectations influenced disinflation costs.
  • 1989–1993: Bank of Canada’s zero-inflation target; inflation fell, unemployment rose, then gradually recovered as expectations anchored.
  • 1990s–2000s: anchored expectations and policy credibility helped stabilize inflation near the target with relatively modest unemployment changes.
  • 2008–09 recession: a large AD shock; inflation fell while unemployment rose; recovery involved a rebalancing of the SRPC as expectations remained anchored to the inflation target.

Real-world implications and takeaways

  • Short-run inflation–unemployment trade-off exists due to expectations and price/wage setting in the short run, but it is not persistent in the long run.
  • Anchored expectations and credible inflation targeting can reduce the social and economic costs of disinflation.
  • Supply shocks can alter the inflation–unemployment relationship temporarily, creating stagflation and challenging policy choices.
  • Labor-market policies and structural reforms can influence the natural rate of unemployment and shift the long-run Phillips curve, with implications for growth and inflation stability.
  • Policy design should balance credibility, timely responses to shocks, and the desire to minimize the long-run sacrifice cost when reducing inflation.

Note: Figures referenced (e.g., Figures 17.1–17.15) illustrate points such as the basic Phillips curve, AD–AS illustrations, the long-run vertical Phillips curve, supply-shock shifts, the sacrifice ratio illustrations, and historical Canadian data during the 1970s–1990s. These notes reproduce the key ideas and numerical relationships without reproducing the images themselves.