chap 35shortruntradeoff
DESCRIPTION
Chapter 35TRANSCRIPT
1
The Short-RunTradeoff betweenInflation andUnemployment
Chapter 33
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Unemployment and Inflation
u The natural rate of unemploymentdepends on various features of thelabor market.
u Examples include minimum-wage laws,the market power of unions, the role ofefficiency wages, and the effectivenessof job search.
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Unemployment and Inflation
u The inflation rate depends primarilyon growth in the quantity of money,controlled by the Fed.
u The misery index, one measure of the“health” of the economy, adds togetherthe inflation rate and unemploymentrate.
2
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Unemployment and Inflation
u Society faces a short-run tradeoff betweenunemployment and inflation.
u If policymakers expand aggregate demand, they can lower unemployment,but only at the cost of higher inflation.
u If they contract aggregate demand, theycan lower inflation, but at the cost of temporarily higher unemployment.
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The Phillips Curve
The Phillips curve illustrates theshort-run relationship betweeninflation and unemployment.
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The Phillips Curve...
UnemploymentRate (percent)
0
InflationRate
(percentper year)
4
B6
A
7
2
Phillips curve
3
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Aggregate Demand, AggregateSupply, and the Phillips Curve
u The Phillips curve shows the short-runcombinations of unemployment andinflation that arise as shifts in theaggregate demand curve move theeconomy along the short-run aggregatesupply curve.
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Aggregate Demand, AggregateSupply, and the Phillips Curve
u The greater the aggregate demand forgoods and services, the greater is theeconomy’s output, and the higher is theoverall price level.
u A higher level of output results in a lowerlevel of unemployment.
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How the Phillips Curve is Related to the Modelof Aggregate Demand and Aggregate Supply...
Phillips curve
0
(b) The Phillips Curve
Inflation Rate(percent per
year)
UnemploymentRate (percent)
0
(a) The Model of AD and AS
Price Level
Low AD
High AD
B
4
6
(output is8,000)
A
7
2
(output is7,500)
A
7,500
102
(unemploymentis 7%)
B
8,000
106
(unemploymentis 7%)
Short-runAS
4
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Shifts in the Phillips Curve:The Role of Expectations
The Phillips curve seems to offerpolicymakers a menu of possibleinflation and unemployment outcomes.
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The Long-Run Phillips Curve
u In the 1960s, Friedman and Phelpsconcluded that inflation andunemployment are unrelated in the longrun.u As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
u Monetary policy could be effective in theshort run but not in the long run.
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The Long-Run Phillips Curve...
UnemploymentRate0 Natural rate of
unemployment
InflationRate Long-run
Phillips curve
BHigh
inflation1. When theFed increasesthe growthrate of themoneysupply, therate ofinflationincreases…
2. … butunemploymentremains at itsnatural ratein the long run.ALow
inflation
5
Natural rate ofunemployment
Long-run Phillipscurve
0
(b) The Phillips Curve
InflationRate
A
Natural rate ofoutput
0
P1
Aggregatedemand, AD1
Long-run aggregatesupply
(a) The Model of AggregateDemand and Aggregate Supply
PriceLevel
4. …but leaves output and unemploymentat their natural rates.
How the Phillips Curve is Related to theModel of Aggregate Demand andAggregate Supply…
P2
2. …raises theprice level…
Quantity of Output
Unemploy-ment Rate
1. An increase in themoney supply increasesaggregate demand…
AD2
B
3. …andincreases theinflation rate…
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Expectations and theShort-Run Phillips Curve
Expected inflation measureshow much people expect theoverall price level to change.
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Expectations and theShort-Run Phillips Curve
u In the long run, expected inflation adjuststo changes in actual inflation.
u The Fed’s ability to create unexpectedinflation exists only in the short run.u Once people anticipate inflation, the only
way to get unemployment below the naturalrate is for actual inflation to be above theanticipated rate.
6
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Expectations and theShort-Run Phillips Curve
UnemploymentRate =
Natural rate ofunemployment
Actual Expectedinflation inflation
-( )a-
This equation relates the unemployment rateto the natural rate of unemployment, actual
inflation, and expected inflation.
How Expected Inflation Shifts theShort-Run Phillips Curve...
UnemploymentRate
0 Natural rate ofunemployment
Inflation Rate
CB
Long-runPhillips curve
A
Short-run Phillips curve withhigh expected inflation
Short-run Phillips curve withlow expected inflation
1. Expansionarypolicy movesthe economy upalong the short-run Phillipscurve...
2. …but in the long-run,expected inflation rises,and the short-run Phillipscurve shifts to the right.
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The Natural-Rate Hypothesis
u The view that unemploymenteventually returns to its natural rate,regardless of the rate of inflation, iscalled the natural-rate hypothesis.
u Historical observations support thenatural-rate hypothesis.
7
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The Natural Experiment for theNatural Rate Hypothesis
u The concept of a stable Phillips curvebroke down in the in the early ’70s.
u During the ’70s and ’80s, the economyexperienced high inflation and high unemployment simultaneously.
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The Phillips Curve in the 1960s...
Unemployment Rate (percent)
Inflation Rate(percent per year)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
1968
1966
19611962
1963
1967
1965 1964
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The Breakdown of the Phillips Curve...
Unemployment Rate (percent)
Inflation Rate(percent per year)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
197319711969
19701968
1966
19611962
1963
1967
1965 1964
1972
8
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Shifts in the Phillips Curve:The Role of Supply Shocks
u Historical events have shown that theshort-run Phillips curve can shift due tochanges in expectations.
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Shifts in the Phillips Curve:The Role of Supply Shocks
u The short-run Phillips curve also shiftsbecause of shocks to aggregate supply.u Major adverse changes in aggregate supply
can worsen the short-run tradeoff betweenunemployment and inflation.
u An adverse supply shock gives policymakersa less favorable tradeoff between inflationand unemployment.
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Shifts in the Phillips Curve:The Role of Supply Shocks
u A supply shock is an event that directlyaffects firms’ costs of production andthus the prices they charge.
u It shifts the economy’s aggregatesupply curve...
u … and as a result, the Phillips curve.
9
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AS2
1. An adverseshift in aggregatesupply…
An Adverse Shock to AggregateSupply...
Quantity of Output
0
PriceLevel
P1Aggregate
demand
(a) The Model of AggregateDemand and Aggregate Supply
Unemployment Rate0
(b) The Phillips Curve
A
InflationRate
Phillips curve, PC1
Aggregatesupply, AS1
A
Y1
P2
3. …and raises theprice level…
B
2. …lowers output…
Y2
B
4. …giving policymakersa less favorable tradeoffbetween unemploymentand inflation.
PC2
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Shifts in the Phillips Curve:The Role of Supply Shocks
u In the 1970s, policymakers faced twochoices when OPEC cut output andraised worldwide prices of petroleum.u Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
u Fight inflation by contracting aggregatedemand and endure even higherunemployment.
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Inflation Rate(percent per year)
UnemploymentRate (percent)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
The Supply Shocks of the 1970s...
1972
19751981
1976
19781979
1980
1973
1974
1977
10
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The Cost of Reducing Inflation
u To reduce inflation, the Fed has to pursuecontractionary monetary policy.
u When the Fed slows the rate of moneygrowth, it contracts aggregate demand.
u This reduces the quantity of goods andservices that firms produce.
u This leads to a rise in unemployment.
A
Short-run Phillips curvewith high expected
inflation
1. Contractionary policymoves the economydown along the short-runPhillips curve...
UnemploymentRate
0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
CB
Short-run Phillips curvewith low expected
inflation
2. ... but in the long run, expected inflation fallsand the short-run Phillips curve shifts to the left.
Disinflationary Monetary Policy in theShort Run and the Long Run...
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The Cost of Reducing Inflation
u To reduce inflation, an economy mustendure a period of high unemploymentand low output.u When the Fed combats inflation, the
economy moves down the short-run Phillipscurve.
u The economy experiences lower inflation butat the cost of higher unemployment.
11
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The Cost of Reducing Inflation
u The sacrifice ratio is the number ofpercentage points of annual output that islost in the process of reducing inflationby one percentage point.u An estimate of the sacrifice ratio is five.
u To reduce inflation from about 10% in1979-1981 to 4% would have required an estimated sacrifice of 30% of annual output!
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Rational Expectations
The theory of rational expectationssuggests that people optimally use allthe information they have, includinginformation about government policies,when forecasting the future.
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Rational Expectations
u Expected inflation explains why there is atradeoff between inflation andunemployment in the short run but not inthe long run.
u How quickly the short-run tradeoffdisappears depends on how quicklyexpectations adjust.
12
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Rational Expectations
u The theory of rational expectationssuggests that the sacrifice-ratio could bemuch smaller than estimated.
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The Volcker Disinflation
u When Paul Volcker was Fed chairman inthe 1970s, inflation was widely viewed asone of the nation’s foremost problems.
u Volcker succeeded in reducing inflation(from 10% to 4%), but at the cost of highemployment (about 10% in 1983).
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UnemploymentRate (percent)
Inflation Rate(percent per year)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
The Volcker Disinflation...
1979
1980
1983
1981
1982
1984
1986
19871985
A
B
C
13
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The Greenspan Era
u Alan Greenspan’s term as Fed chairmanbegan with a favorable supply shock.u In 1986, OPEC members abandoned their
agreement to restrict supply.
u This led to falling inflation and fallingunemployment.
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UnemploymentRate (percent)
0 1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Inflation Rate(percent per year)
The Greenspan Era...
19841991
19851992
19931986
1994
19881987
1995
19891990
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The Greenspan Era
u Fluctuations in inflation andunemployment in recent years have beenrelatively small due to the Fed’s actions.
14
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Summaryu The Phillips curve describes a negative
relationship between inflation andunemployment.
u By expanding aggregate demand,policymakers can choose a point on thePhillips curve with higher inflation and lowerunemployment.
u By contracting aggregate demand,policymakers can choose a point on thePhillips curve with lower inflation and higherunemployment.
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Summary
u The tradeoff between inflation andunemployment described by the Phillipscurve holds only in the short run.
u The long-run Phillips curve is vertical atthe natural rate of unemployment.
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Summary
u The short-run Phillips curve also shiftsbecause of shocks to aggregate supply.
u An adverse supply shock givespolicymakers a less favorable tradeoffbetween inflation and unemployment.
15
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Summary
u When the Fed contracts growth in themoney supply to reduce inflation, itmoves the economy along the short-runPhillips curve.
u This results in temporarily highunemployment.
u The cost of disinflation depends on howquickly expectations of inflation fall.
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Summary
u Because monetary and fiscal policy caninfluence aggregate demand, thegovernment sometimes uses these policyinstruments in an attempt to stabilize theeconomy.
u Changes in attitudes by households andfirms shift aggregate demand; if thegovernment does not respond, the result isundesirable and unnecessary fluctuations in output and employment.
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GraphicalReview
16
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The Phillips Curve...
UnemploymentRate (percent)
0
InflationRate
(percentper year)
4
B6
A
7
2
Phillips curve
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How the Phillips Curve is Related to the Modelof Aggregate Demand and Aggregate Supply...
Phillips curve
0
(b) The Phillips Curve
Inflation Rate(percent per
year)
UnemploymentRate (percent)
0
(a) The Model of AD and AS
Price Level
Low AD
High AD
B
4
6
(output is8,000)
A
7
2
(output is7,500)
A
7,500
102
(unemploymentis 7%)
B
8,000
106
(unemploymentis 7%)
Short-runAS
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The Long-Run Phillips Curve...
UnemploymentRate0 Natural rate of
unemployment
InflationRate Long-run
Phillips curve
BHigh
inflation1. When theFed increasesthe growthrate of themoneysupply, therate ofinflationincreases…
2. … butunemploymentremains at itsnatural ratein the long run.ALow
inflation
17
How the Phillips Curve is Related to theModel of Aggregate Demand andAggregate Supply…
Natural rate ofunemployment
Long-run Phillipscurve
0
(b) The Phillips Curve
InflationRate
A
Natural rate ofoutput
0
P1
Aggregatedemand, AD1
Long-run aggregatesupply
(a) The Model of AggregateDemand and Aggregate Supply
PriceLevel
4. …but leaves output and unemploymentat their natural rates.
P2
2. …raises theprice level…
Quantity of Output
Unemploy-ment Rate
1. An increase in themoney supply increasesaggregate demand…
AD2
B
3. …andincreases theinflation rate…
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How Expected Inflation Shifts theShort-Run Phillips Curve...
UnemploymentRate
0 Natural rate ofunemployment
Inflation Rate
CB
Long-runPhillips curve
A
Short-run Phillips curve withhigh expected inflation
Short-run Phillips curve withlow expected inflation
1. Expansionarypolicy movesthe economy upalong the short-run Phillipscurve...
2. …but in the long-run,expected inflation rises,and the short-run Phillipscurve shifts to the right.
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The Phillips Curve in the 1960s...
Unemployment Rate (percent)
Inflation Rate(percent per year)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
1968
1966
19611962
1963
1967
1965 1964
18
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The Breakdown of the Phillips Curve...
Unemployment Rate (percent)
Inflation Rate(percent per year)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
197319711969
19701968
1966
19611962
1963
1967
1965 1964
1972
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An Adverse Shock to AggregateSupply...
AS2
1. An adverseshift in aggregatesupply…
Quantity of Output
0
PriceLevel
P1Aggregate
demand
(a) The Model of AggregateDemand and Aggregate Supply
Unemployment Rate0
(b) The Phillips Curve
A
InflationRate
Phillips curve, PC1
Aggregatesupply, AS1
A
Y1
P2
3. …and raises theprice level…
B
2. …lowers output…
Y2
B
4. …giving policymakersa less favorable tradeoffbetween unemploymentand inflation.
PC2
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The Supply Shocks of the 1970s...Inflation Rate
(percent per year)
UnemploymentRate (percent)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
1972
19751981
1976
19781979
1980
1973
1974
1977
19
A
Short-run Phillips curvewith high expected
inflation
1. Contractionary policymoves the economydown along the short-runPhillips curve...
UnemploymentRate
0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
CB
Short-run Phillips curvewith low expected
inflation
2. ... but in the long run, expected inflation fallsand the short-run Phillips curve shifts to the left.
Disinflationary Monetary Policy in theShort Run and the Long Run...
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The Volcker Disinflation...
UnemploymentRate (percent)
Inflation Rate(percent per year)
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
1979
1980
1983
1981
1982
1984
1986
19871985
A
B
C
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The Greenspan Era...
UnemploymentRate (percent)
0 1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Inflation Rate(percent per year)
19841991
19851992
19931986
1994
19881987
1995
19891990