copyright © 2004 south-western 22 the short-run tradeoff between inflation and unemployment
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Copyright © 2004 South-Western
2222The Short-Run Tradeoff between
Inflation and Unemployment
Copyright © 2004 South-Western
Unemployment and Inflation
• The natural rate of unemployment depends on various features of the labor market.
• Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search.
• The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.
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Unemployment and Inflation
• Society faces a short-run tradeoff between unemployment and inflation.
• If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.
• If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.
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THE PHILLIPS CURVE
• The Phillips curve illustrates the short-run relationship between inflation and unemployment.
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Figure 1 The Phillips Curve
UnemploymentRate (percent)
0
InflationRate
(percentper year)
Phillips curve
4
B6
7
A2
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Aggregate Demand, Aggregate Supply, and the Phillips Curve
• The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.
• It is drawn for one level of AS. A shift of AS will generate a new level of the Phillips curve.
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Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
Quantityof Output
0
Short-runaggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
UnemploymentRate (percent)
0
InflationRate
(percentper year)
PriceLevel
(b) The Phillips Curve
Phillips curveLow aggregate
demand
Highaggregate demand
(output is8,000)
B
4
6
(output is7,500)
A
7
2
8,000(unemployment
is 4%)
106 B
(unemploymentis 7%)
7,500
102 A
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The Long-Run Phillips Curve
• Long-run Phillips curve is vertical
• It represents the natural rate of unemployment
• It may be shifted by changes in the labor market, such as increases in unemployment compensation, changes in minimum wage laws.
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Figure 3 The Long-Run Phillips Curve
UnemploymentRate
0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
BHighinflation
Lowinflation
A
2. . . . but unemploymentremains at its natural ratein the long run.
1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .
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Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
Quantityof Output
Natural rateof output
Natural rate ofunemployment
0
PriceLevel
P
Aggregatedemand, AD
Long-run aggregatesupply
Long-run Phillipscurve
(a) The Model of Aggregate Demand and Aggregate Supply
UnemploymentRate
0
InflationRate
(b) The Phillips Curve
2. . . . raisesthe pricelevel . . .
1. An increase in the money supplyincreases aggregatedemand . . .
AAD2
B
A
4. . . . but leaves output and unemploymentat their natural rates.
3. . . . andincreases theinflation rate . . .
P2B
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• This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.
Expectations and the Short-Run Phillips Curve
N atu ra l ra te o f u n em p lo y m en t - a A ctu a l in fla tio n
E x p ec ted in fla tio n
Unemployment Rate =
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Figure 5 How Expected Inflation Shifts the Short-Run Phillips Curve
UnemploymentRate
0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
Short-run Phillips curvewith high expected
inflation
Short-run Phillips curvewith low expected
inflation
1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .
2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.
CB
A
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The Natural Experiment for the Natural-Rate Hypothesis
• The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.
• Historical observations support the natural-rate hypothesis.
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Figure 6 The Phillips Curve in the 1960s
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
UnemploymentRate (percent)
Inflation Rate(percent per year)
1968
1966
19611962
1963
1967
19651964
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Figure 7 The Shift of the Phillips Curve
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
UnemploymentRate (percent)
Inflation Rate(percent per year)
1973
1966
1972
1971
19611962
1963
1967
19681969 1970
19651964
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SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS
• The short-run Phillips curve also shifts because of shocks to aggregate supply. • Major adverse changes in aggregate supply can
worsen the short-run tradeoff between unemployment and inflation.
• An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.
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Figure 8 An Adverse Shock to Aggregate Supply
Quantityof Output
0
PriceLevel
Aggregatedemand
(a) The Model of Aggregate Demand and Aggregate Supply
UnemploymentRate
0
InflationRate
(b) The Phillips Curve
3. . . . andraises the price level . . .
AS2 Aggregatesupply, AS
A
1. An adverseshift in aggregate supply . . .
4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.
BP2
Y2
PA
Y
Phillips curve, PC
2. . . . lowers output . . .
PC2
B
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Figure 9 The Supply Shocks of the 1970s
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
UnemploymentRate (percent)
Inflation Rate(percent per year)
1972
19751981
1976
1978
1979
1980
1973
1974
1977
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THE COST OF REDUCING INFLATION
• To reduce inflation, the Fed has to pursue contractionary monetary policy policy.
• When the Fed slows the rate of money growth, it contracts aggregate demand.
• This reduces the quantity of goods and services that firms produce.
• This leads to a rise in unemployment.
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Figure 10 Disinflationary Monetary Policy in the Short Run and the Long Run
UnemploymentRate
0 Natural rate ofunemployment
InflationRate
Long-runPhillips curve
Short-run Phillips curvewith high expected
inflation
Short-run Phillips curvewith low expected
inflation
1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .
2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.
BC
A
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THE COST OF REDUCING INFLATION
• To reduce inflation, an economy must endure a period of high unemployment and low output.• When the Fed combats inflation, the economy
moves down the short-run Phillips curve.• The economy experiences lower inflation but at the
cost of higher unemployment.
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Rational Expectations and the Possibility of Costless Disinflation
• Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run.
• How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.
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The Volcker Disinflation
• When Paul Volcker became Fed chairman in the 1980, inflation was widely viewed as one of the nation’s foremost problems.
• Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high unemployment (about 10 percent in 1983).
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Figure 11 The Volcker Disinflation
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
UnemploymentRate (percent)
Inflation Rate(percent per year)
1980 1981
1982
1984
1986
1985
1979A
1983B
1987
C
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Figure 12 The Greenspan Era
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
UnemploymentRate (percent)
Inflation Rate(percent per year)
19841991
1985
19921986
19931994
198819871995
199620021998
1999
20002001
19891990
1997
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Positive changes in Aggregate Supply
• The best way to achieve low inflation and low unemployment is to experience an increase in the aggregate supply.
• Increase in AS moves Phillips curve to a lower level, giving the government a better trade-off between inflation and unemployment.
• Example: technological change in the 1990s.
• Problem: AS cannot be freely changed by government policy.