12 - Tradeoff between Inflation and Unemployment

The Short-Run Tradeoff between Inflation and Unemployment

• In the long run, inflation and unemployment are unrelated, as inflation depends on money supply growth, while unemployment depends on factors like minimum wage, union power, efficiency wages, and job search processes.
• In the short run, there exists a tradeoff between inflation and unemployment, which is a key principle in economics.

The Phillips Curve

• The Phillips curve illustrates the short-run tradeoff between inflation and unemployment.
• A.W. Phillips (1958) found a negative correlation between nominal wage growth and unemployment in the U.K.
• Paul Samuelson & Robert Solow (1960) discovered a similar negative correlation between U.S. inflation and unemployment, naming it the “Phillips Curve.”

Deriving the Phillips Curve

• Assume the current price level $P = 100$.
• Two possible outcomes for the next year:
  • A. Low Aggregate Demand (AD): small increase in $P$ (low inflation), low output, high unemployment.
  • B. High Aggregate Demand (AD): big increase in $P$ (high inflation), high output, low unemployment.

The Phillips Curve as a Policy Menu

• Fiscal and monetary policies influence AD, suggesting the Phillips Curve offers policymakers choices between:
  • Low unemployment with high inflation.
  • Low inflation with high unemployment.
  • Any combination in between.
• 1960s: U.S. data supported the Phillips Curve, leading to the belief in its stability and reliability.

Evidence for the Phillips Curve?

• During the 1960s, U.S. policymakers prioritized reducing unemployment, accepting higher inflation rates.

The Vertical Long-Run Phillips Curve

• 1968: Milton Friedman and Edmund Phelps argued the tradeoff is temporary.
• Natural-rate hypothesis: unemployment returns to its natural rate regardless of inflation.
• Based on the classical dichotomy and the vertical Long-Run Aggregate Supply (LRAS) curve.
• In the long run, increased money growth leads only to faster inflation.

Reconciling Theory and Evidence

• Evidence from the 1960s: Phillips Curve slopes downward.
• Theory (Friedman and Phelps): Phillips Curve is vertical in the long run.
• Resolution: Friedman and Phelps introduced expected inflation, which is a measure of how much people expect the price level to change over time.

The Phillips Curve Equation

• The Phillips Curve equation is:

$Unemployment Rate = Natural Rate of Unemployment - a(Actual Inflation - Expected Inflation)$

• Short run:
  • Central Banks (CB) can lower the unemployment rate below the natural rate by making inflation greater than expected.
• Long run:
  • Expectations align with reality, and the unemployment rate returns to the natural rate, irrespective of the inflation level.

How Expected Inflation Shifts the PC

• Initially, expected and actual inflation are at $3\%$, and unemployment is at the natural rate of $6\%$.
• If the Central Bank raises inflation $2\%$ higher than expected, unemployment falls to $4\%$.
• In the long run, expected inflation rises to $5\%$, shifting the Phillips Curve upwards, and unemployment returns to its natural rate.

The Breakdown of the Phillips Curve

• Early 1970s: unemployment increased despite higher inflation.
• Explanation by Friedman & Phelps: expectations were catching up with reality.

Another PC Shifter: Supply Shocks

• Supply shock: an event that directly changes firms’ costs and prices, thereby shifting the Aggregate Supply (AS) and Phillips Curve.
• Example: a large increase in oil prices.

How an Adverse Supply Shock Shifts the PC

• Short-Run Aggregate Supply (SRAS) shifts left, increasing prices while decreasing output and employment.
• Both inflation and unemployment increase as the Phillips Curve shifts upward.

The 1970s Oil Price Shocks

• Supply shocks and rising expected inflation worsened the Phillips Curve tradeoff.

The Cost of Reducing Inflation

Disinflation

• Disinflation: a reduction in the inflation rate.
• To reduce inflation, the Central Bank must decrease the rate of money growth, which reduces Aggregate Demand.
• Short run: Output falls, and unemployment rises.
• Long run: Output and unemployment return to their natural rates.

Disinflationary Monetary Policy

• Contractionary monetary policy moves the economy from point A to point B.
• Over time, expected inflation decreases, and the Phillips Curve shifts downward.
• In the long run, at point C, the economy reaches the natural rate of unemployment with lower inflation.

Sacrifice Ratio

• The sacrifice ratio is defined as: percentage points of annual output lost per 1 percentage point reduction in inflation
• Typical estimate: 5.
  • To reduce inflation by $1\%$, a sacrifice of $5\%$ of a year’s output is required.
• The cost can be spread over time.
  • To reduce inflation by $6\%$, either sacrifice $30\%$ of GDP for one year or sacrifice $10\%$ of GDP for three years.

Rational Expectations, Costless Disinflation?

• Rational expectations: people optimally use all available information, including government policies, when forecasting the future.
• Disinflation could be much less costly if the central bank convinces everyone of its commitment to reducing inflation.
• Expected inflation falls, and the short-run Phillips Curve shifts downward.
• Result: Disinflation can cause less unemployment than traditional models predict.

Conclusion

• The theories discussed originate from some of the 20th century’s greatest economists.
• Key takeaways:
  • Inflation and unemployment are unrelated in the long run.
  • They are negatively related in the short run.
  • Expectations significantly affect the economy’s adjustment from the short run to the long run.