Chapter 22: The Short-Run Trade-off between Inflation and Unemployment

The Phillips Curve

The Phillips Curve illustrates the short-run trade-off between inflation and unemployment.
Long Run: Inflation and unemployment are unrelated; inflation depends on money supply growth, and unemployment depends on labor market features.
- These features include job search, minimum-wage laws, union power, and efficiency wages.
Short Run: Society faces a trade-off between inflation and unemployment.

Origins of the Phillips Curve

Phillips Curve: A curve that shows the short-run trade-off between inflation and unemployment.
1958: A.W. Phillips: Discovered a negative correlation between nominal wage growth and unemployment in the U.K.
1960: Paul Samuelson and Robert Solow: Found a negative correlation between inflation and unemployment, naming it the “Phillips Curve”.

The Phillips Curve: A Policy Menu?

Policymakers face a trade-off between inflation and unemployment.
Fiscal and monetary policies can influence the aggregate-demand curve, allowing policymakers to choose a point on the Phillips curve.
- Expanding aggregate demand leads to higher inflation and lower unemployment.
- Contracting aggregate demand leads to lower inflation and higher unemployment.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The Phillips curve shows combinations of inflation and unemployment that arise as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve.
Example: Increase in Aggregate Demand
- Results in larger output and a higher price level.
- Leads to lower unemployment and higher inflation.

Shifts in the Phillips Curve: The Role of Expectations

The Long-Run Phillips Curve

1968: Milton Friedman and Edmund Phelps: Argued that classical theory suggests money supply growth is the primary determinant of inflation.
Long Run:
- Inflation and unemployment are unrelated.
- Expected inflation adjusts to changes in actual inflation, shifting the short-run Phillips curve.
- The long-run Phillips curve is vertical at the natural rate of unemployment.
According to Friedman, monetary policymakers face a long-run Phillips curve that is vertical.
- Slow Money Supply Growth: Low inflation rate and unemployment at the natural rate.
- Quick Money Supply Growth: High inflation rate and unemployment at the natural rate.

Vertical Long-Run Phillips Curve

The vertical long-run Phillips curve expresses the classical idea of monetary neutrality.
The vertical long-run aggregate-supply curve and Phillips curve imply that monetary policy:
- Influences nominal variables (price level and inflation rate).
- Does not influence real variables (output and unemployment).
In the long run, regardless of the monetary policy pursued by the Fed:
- Output is at its natural level.
- Unemployment is at its natural rate.

The Meaning of “Natural”

Natural Rate of Unemployment: The rate toward which the economy gravitates in the long run.
- Not necessarily socially desirable.
- Not constant over time.
- Beyond the influence of monetary policy.
Labor-market policies can affect the natural rate of unemployment.
- Reducing the natural rate shifts the long-run Phillips curve left and the long-run aggregate-supply curve right.
- Results in lower unemployment and higher output for any given rate of money growth and inflation.

Reconciling Theory and Evidence

Evidence (Phillips, Samuelson, Solow): The Phillips curve slopes downward.
Theory (Friedman and Phelps): The Phillips curve is vertical in the long run.
Friedman and Phelps bridged the gap by introducing expected inflation.
Expected Inflation: A measure of how much people expect the price level to change.
Friedman and Phelps:
- The short-run aggregate-supply curve slopes upward.
- The long-run aggregate-supply curve is vertical.
- The long-run Phillips curve is also vertical.
- Expectations are key to understanding how the short run and long run are related.

The Short-Run Phillips Curve

Short Run: The Fed can reduce the unemployment rate below the natural rate by making inflation greater than expected.
Long Run: Expectations catch up to reality, and the unemployment rate returns to the natural rate, regardless of whether inflation is high or low.

Active Learning 1: A Numerical Example

Natural rate of unemployment = 5%; Expected inflation = 2%; $\,alpha = 0.5$
- Plot the long-run Phillips curve.
- Find the unemployment rate for actual inflation rates of 0% and 6%.
- Sketch the short-run Phillips curve.
- Suppose expected inflation rises to 4%; repeat part B.
- Suppose the natural rate falls to 4%; draw the new long-run Phillips curve, then repeat part B.
An increase in expected inflation shifts the Phillips curve to the right.
A fall in the natural rate shifts both curves to the left.

The Natural Experiment for the Natural-Rate Hypothesis

Natural-Rate Hypothesis: The claim that unemployment eventually returns to its normal (natural) rate, regardless of the rate of inflation.
- Predicted by Friedman and Phelps in 1968.
- Inadvertently tested by policymakers in the late 1960s and early 1970s.

Shifts in the Phillips Curve: The Role of Supply Shocks

Supply Shocks

Supply Shock: An event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and thus the Phillips curve.
- Example: Higher oil prices in 1974 and 1979.
- 1973: The Fed accommodated the first shock with faster money growth, resulting in higher expected inflation, which further shifted the Phillips curve.
- 1979: Oil prices surged again, worsening the Fed’s trade-off.
An adverse supply shock (e.g., an increase in world oil prices) gives policymakers a less favorable trade-off between inflation and unemployment.
- Policymakers must accept:
  - A higher rate of inflation for any given rate of unemployment, or
  - A higher rate of unemployment for any given rate of inflation.

The Cost of Reducing Inflation

Disinflation and Deflation

Disinflation: A reduction in the inflation rate.
Deflation: A reduction in the price level.

Disinflationary Monetary Policy

To reduce inflation, the Fed must pursue contractionary monetary policy, which reduces aggregate demand.
- Short Run: Output falls and unemployment rises.
- Long Run: Output and unemployment return to their natural rates.

The Sacrifice Ratio

Sacrifice Ratio: The number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point.
- Typical Estimate: A sacrifice ratio of 5.
- To reduce inflation by 1%, 5% of a year’s output must be sacrificed.
Example:
- 1979: 10% inflation.
- To reduce inflation by 6%, annual output would fall by 30%.

Rational Expectations and the Possibility of Costless Disinflation

Rational Expectations: The theory that people optimally use all available knowledge, including information about government policies, when forecasting the future.
- Early Proponents: Robert Lucas, Thomas Sargent, Robert Barro.
- Implied that disinflation could be much less costly.

The Volcker Disinflation

Fed Chair Paul Volcker: Appointed in late 1979 during high inflation and unemployment.
Changed Fed policy to disinflation.
1981–1984: Fiscal policy was expansionary, so Fed policy had to be very contractionary to reduce inflation.
Success: Inflation fell from 10% to 4%, but at the cost of high unemployment.

Recent History

The Greenspan Era

1986, Favorable Supply Shock: Oil prices fell by 50%.
- Drop in inflation and unemployment (1984-1986).
1989–90: Unemployment fell, and inflation rose.
- The Fed raised interest rates, causing a small recession in 1991 and 1992.
Rest of the 1990s: Technological boom and economic prosperity.
- Unemployment and inflation fell.
2001: End of the dot-com stock market bubble, 9/11 terrorist attacks, and corporate accounting scandals depressed aggregate demand.
- First recession in a decade.
- Policymakers responded with expansionary monetary and fiscal policy.
By 2005: Natural rate of unemployment.

The Great Recession

Early 2000s: The housing market boom turned to bust in 2006.
- Household wealth fell.
- Millions of mortgage defaults and foreclosures.
- Heavy losses at financial institutions.
- Result: Sharp drop in aggregate demand and a steep rise in unemployment.
2007 to 2010: Decline in aggregate demand.
- Raised unemployment (from below 5% to 10%).
- Reduced the rate of inflation (from 3% to 1%).
After 2010: Slow recovery.
- Unemployment gradually declined.
- The rate of inflation remained between 1 and 2%.
- Expected inflation steady at about 2%.
- The short-run Phillips curve was relatively stable.

The Pandemic

2020: The coronavirus pandemic led to a sharp recession.
- Decline in aggregate demand and aggregate supply.
- The unemployment rate jumped from 3.5% to 14.8%.
- The CPI fell by 1% (a brief period of deflation).
- Aggregate demand recovered quickly due to expansionary monetary and fiscal policies.

The Pandemic and Supply Chains

Consistently adverse effect on aggregate supply.
- Early: Non-essential businesses closed.
- After Restrictions Relaxed: People were reluctant to return to work.
- Disruption of global supply chains.
- The inability of some businesses to obtain critical inputs further contracted aggregate supply.

The Pandemic and Inflation

End of 2021:
- The unemployment rate was below 5%.
- The consumer price index rose to 7.5% (January 2022).
- Policymakers: The inflation surge was transitory.
- Some economists: Monetary and fiscal expansion had been excessive, and inflation would not soon return to the Fed’s target of 2%.

Conclusion

Discussed the ideas of many of the best economists of the 20th century.
- Phillips curve of Phillips, Samuelson, and Solow.
- Natural-rate hypothesis of Friedman and Phelps.
- Rational-expectations theory of Lucas, Sargent, and Barro.
Milton Friedman (1968): “There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off…But how long, you will say, is “temporary”?…”