Chapter 22 Notes: Inflation and Unemployment

The Short-Run Trade-off between Inflation and Unemployment

Introduction

Two key indicators of economic performance are inflation and unemployment.
The "misery index" (inflation rate + unemployment rate) is used to gauge economic health.
In the long run, unemployment depends on labor market features (minimum wage, unions, efficiency wages, job search).
Inflation primarily depends on the central bank's control of the money supply.
In the short run, there is a trade-off between inflation and unemployment.
Expanding aggregate demand reduces unemployment but increases inflation.
Contracting aggregate demand reduces inflation but increases unemployment.

The Phillips Curve

The Phillips curve represents the short-run relationship between inflation and unemployment.

Origins of the Phillips Curve

A.W. Phillips (1958) found a negative correlation between unemployment and inflation in the UK (1861-1957).
Low unemployment tends to coincide with high inflation, and vice versa.
Samuelson and Solow (1960) found a similar correlation in the U.S. data.
They attributed this to high aggregate demand associated with low unemployment, putting upward pressure on wages and prices.
Phillips curve: A curve that shows the short-run trade-off between inflation and unemployment.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The Phillips curve reflects combinations of inflation and unemployment arising from shifts in the aggregate-demand curve along the short-run aggregate-supply curve.
Increased aggregate demand leads to higher output and price levels (inflation) but lower unemployment.
Decreased aggregate demand leads to lower output and price levels but higher unemployment.
Monetary and fiscal policies can shift the aggregate-demand curve and move the economy along the Phillips curve.
Example:
- Price level in 2020 = 100.
- Low aggregate demand (Outcome A): Output = 15,000, Price level = 102.
- High aggregate demand (Outcome B): Output = 16,000, Price level = 106.
- Unemployment in Outcome A = 7%, Inflation rate = 2%.
- Unemployment in Outcome B = 4%, Inflation rate = 6%.

Shifts in the Phillips Curve: The Role of Expectations

Economists questioned the stability of the Phillips curve in the late 1960s.

The Long-Run Phillips Curve

Friedman (1968) and Phelps argued against a long-run trade-off between inflation and unemployment.
Classical theory suggests money supply primarily determines inflation but doesn't affect real variables like employment.
In the long run, inflation and unemployment are unrelated.
Monetary policy can control nominal quantities (exchange rate, price level) but not real quantities (real interest rate, unemployment).
The long-run Phillips curve is vertical at the natural rate of unemployment.
$<br /> \text{Natural rate of unemployment} = \text{Unemployment rate toward which the economy gravitates in the long run} <br />$

The Meaning of "Natural"

The natural rate of unemployment isn't necessarily socially desirable or constant.
It is beyond the influence of monetary policy.
Policies improving labor market function can reduce the natural rate.
A lower natural rate shifts the long-run Phillips curve to the left & the long-run aggregate-supply curve to the right.

Reconciling Theory and Evidence

Friedman and Phelps reconciled classical theory with the short-run Phillips curve.
The trade-off is only temporary.
In the long run, more expansionary monetary policy leads only to higher inflation.
Expectations are key to understanding the relationship between short run and long run.
Expected inflation: How much people expect the overall price level to change.
In the short run, the Fed can create unexpected inflation by increasing the money supply, but in the long run, people adjust their expectations.

The Short-Run Phillips Curve

The analysis can be summarized by the following equation:
$\text{Unemployment} = \text{Natural rate of unemployment} - a(\text{Actual inflation} - \text{Expected inflation})$
- In the short run, higher actual inflation is associated with lower unemployment.
- In the long run, actual inflation equals expected inflation, and unemployment is at its natural rate.
Each short-run Phillips curve reflects a particular expected rate of inflation.
When expected inflation changes, the short-run Phillips curve shifts.
Policymakers face only a temporary trade-off between inflation and unemployment.
In the long run, expanding aggregate demand rapidly will only lead to higher inflation without reducing unemployment.

Natural Experiment for the Natural-Rate Hypothesis

The natural-rate hypothesis suggests unemployment eventually returns to its natural rate, regardless of inflation.
Data from 1961-1968 traced an almost perfect Phillips curve.
Beginning in the late 1960s, expansionary policies led to high inflation, but unemployment reverted to its natural rate in the early 1970s.

Shifts in the Phillips Curve: The Role of Supply Shocks

Shocks to aggregate supply can also shift the short-run Phillips curve.
Example: OPEC restricting oil supply in 1974.
Supply shock: An event directly affecting firms' costs and prices, shifting the aggregate-supply curve and the Phillips curve.
An oil price increase reduces the quantity of goods and services supplied, leading to stagflation (falling output and rising prices).
The short-run Phillips curve shifts to the right (higher unemployment and inflation).
Policymakers face a trade-off between fighting inflation and fighting unemployment.
The shift's duration depends on how people adjust their expectations of inflation.
In the U.S. during the 1970s, expected inflation rose substantially due to the Fed accommodating the supply shock (increasing aggregate demand).

The Cost of Reducing Inflation

Volcker's disinflation in the 1980s aimed to reduce inflation.
Disinflation: A reduction in the rate of inflation.

The Sacrifice Ratio

To reduce inflation, the Fed pursues contractionary monetary policy, leading to higher unemployment.
The economy moves along the short-run Phillips curve.
Over time, expected inflation falls, and the short-run Phillips curve shifts downward.
Sacrifice ratio: The percentage points of annual output lost to reduce inflation by 1 percentage point.
Typical estimate is 5.
Reducing inflation has a cost of high unemployment and low output.

Rational Expectations and the Possibility of Costless Disinflation

The theory of rational expectations suggests people optimally use all available information, including government policies, when forecasting the future.
When policies change, people adjust their expectations of inflation.
The sacrifice ratio could be much smaller or even zero if the government credibly commits to low inflation.
People would immediately lower their expectations, and the short-run Phillips curve would shift downward. This leads to costless and quick inflation reduction.

The Volcker Disinflation

Volcker succeeded in reducing inflation, but at the cost of high unemployment.
The Volcker disinflation produced a deep recession, but the cost was not as large as many economists had predicted.
The public may not have believed Volcker's commitment, so expected inflation did not fall immediately.

The Greenspan Era

The U.S. economy experienced relatively mild fluctuations in inflation and unemployment.
A favorable supply shock (falling oil prices in 1986) led to falling inflation and unemployment.
The Fed avoided excessive aggregate demand.

A Financial Crisis Takes Us for a Ride along the Phillips Curve

The financial crisis of 2008 resulted in a large decline in aggregate demand and a steep increase in unemployment.
From 2007 to 2010, the economy rode down the short-run Phillips curve.
From 2010 to 2015, the economy recovered.

Conclusion

The trade-off between inflation and unemployment has been a topic of much intellectual turmoil.
There is always a temporary trade-off between inflation and unemployment, but there is no permanent trade-off.
The temporary trade-off arises from unanticipated inflation.
The initial effects of higher and unanticipated inflation last two to five years.