Inflation and Unemployment

Dr. Katherine Sauer

Principles of Macroeconomics
ECO 2010
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Overview:

I. The Short Run Relationships between inflation and unemployment

II. The long run relationship between inflation and unemployment
III.Shifts in the Phillips Curve
IV. Policy Choices

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The misery index is computed as the sum of the inflation rate and
unemployment rate.

high: June 1970 U=7.6% Π=14.38% 21.98%

low: July 1953 U = 2.6% Π=0.37% 2.97%

Sept 2007: U = 4.7% Π=2.76% 7.46%

Feb2009: U = 9.7% Π= 0 9.7%

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The Relationships between inflation and unemployment

In the long run,

- Unemployment will be at its natural rate
- determined by features of the labor market
(min. wage laws, union power, efficiency wages)

- Inflation depends on growth in the money supply

In the short run, there is a tradeoff between unemployment and

inflation.

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I. The short run relationship between inflation and unemployment
Ex1: Suppose that there is an increase in Aggregate Demand

P The price level rises and

AS
RGDP rises.

P2 So, unemployment falls

P1 and inflation rises.

AD2

AD

Y1 Y2 Y

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Ex2: Suppose that there is an decrease in Aggregate Demand

The price level falls and

RGDP falls.
P
AS
So, unemployment rises
and inflation falls.
P1
P2

AD
AD2

Y2 Y1 Y

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The Phillips Curve illustrates the short run tradeoff between
inflation and unemployment.
- shows the combinations of inflation and unemployment
that result from shifts of the AD curve
Π%
In 1958, A.W. Phillips
published an article
discussing the negative
relationship between
inflation and unemployment
in the UK.

The relationship was also

found in the US (Solow and
Phillips Curve Samuelson).

U% 7
When Aggregate Demand increases, there is a movement along
the Phillips Curve.

P
AS Π%

110
105
10%

AD2 5%

AD
Phillips Curve

Y1 Y2 Y 4% 7% U%
(U7%)(U4%)

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II. The long run relationship between inflation and unemployment
Milton Friedman and Edmund Phelps concluded that there is no long
run trade off between inflation and unemployment.

The long run Phillips Curve is vertical at the natural rate of

unemployment.

Recall:
- natural rate of unemployment is the rate that the economy
moves toward in the long run
- may not be a socially desired rate
- it can change over time.

(If the natural rate of unemployment changes, the LR Phillips Curve

will shift.)

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 SRAS2 LR
P Π%
Phillips Curve
LRAS

SRAS
P3 3

P2 2

P1 1 Π3
AD2
Π1
AD

YN Y2 Y UN U%

1) AD increases, pushing up the price level and RGDP

2) In the short run, inflation is higher and unemployment is lower.
3) Because the actual price level is higher, the expected price level
is higher… over the long run Aggregate Supply will shift left.
4) The price level is now higher and unemployment is at the natural
rate 10
Note: the claim that unemployment will eventually return to its
natural rate regardless of the inflation rate is called the Natural Rate
Hypothesis.

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III. Shifts in the Phillips Curve
A. Expectations about inflation
The higher the expected inflation rate, the higher will be the
tradeoff between inflation and unemployment.
1) Initially, there is low actual
Π% LR Phillips
Curve inflation and so there is low
expected inflation.

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2 2) Suppose AD increases…
inflation will be higher and
1 Phillips unemployment lower.
Curve 2
Phillips 3) As actual inflation rises,
Curve
expected inflation does too. This
UN U% shifts the SR Phillips curve to
the right.
When expected inflation increases, the SR Phillips curve increases.
 B. Supply Shocks
Supply shocks (sudden events that shift the Aggregate Supply
curve) will result in a shift of the SR Phillips Curve.

Ex: Suppose there is a sudden increase in the price of oil.

SRAS2
P Π% The Phillips
Curve shifts
SRAS right.
P2

P1
Phillips Curve2

AD
Phillips Curve
Y2 Y1 Y U%
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Both inflation and unemployment are higher.
To recap:
The Long Run Phillips curve illustrates that in the long run,
unemployment will be at its natural rate regardless of the inflation
rate.
- LRPC will shift if the natural rate of unemployment changes

The Short Run Phillips curve illustrates the short run tradeoff
between inflation and unemployment.

When AD shifts, there will be a movement along the Phillips Curve.

When there is a supply shock, the Phillips Curve will shift.

-adverse shock… PC shifts right

When inflation expectations change, the Phillips Curve will shift.

-higher expectations… PC shifts right
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 IV. Policy Choices
Because of the tradeoff between inflation and unemployment,
policy makers must make a choice.
Ex1: After an adverse
Goal of supply shock, inflation and
P returning to Y1 SRAS2
unemployment will both be
higher
SRAS
Suppose Congress is
P2
worried about unhappy
P1 unemployed voters.
- goal would be to
AD increase GDP in order to
decrease unemployment
Y2 Y1 Y
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 To reach that goal, Congress would have to stimulate
Aggregate Demand
- tax cut, more government spending
Aggregate Demand will
shift to the right.
P SRAS2

Unemployment will fall as

SRAS GDP rises.
P3
P2
But now inflation is even
P1 higher.
AD2

AD The Fed might now decide

to use contractionary
Y2 Y1 Y monetary policy to combat
the inflation… 16
 Ex2: After an adverse supply shock, inflation and unemployment
will both be higher
Suppose that we aren’t near any
elections so Congress isn’t too
worried about unemployment.
P SRAS2
Suppose that the Fed, however,
is worried about the inflation.
SRAS
- goal would be to stabilize
P2 the price level at the initial
Goal of level
P1 returning to P1

To reach the goal, the Fed

AD
would use contractionary
monetary policy to decrease
Y2 Y1 Y AD.
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 AD shifts to the left.
P SRAS2
The price level and inflation
SRAS
fall.

P2 But, GDP falls further and

P1 unemployment rises.

Now Congress may want to

AD
AD2 fight unemployment…
Y3 Y2 Y1 Y

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Sometimes the Fed is working with one goal and Congress is
working with another.

The policies can conflict with one another.

(Another case against using policy to stabilize the economy?)

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Note on the Costs of Reducing inflation:

One of the reasons that the Fed is so worried about inflation

getting out of hand is because reducing inflation imposes real
costs on the economy.

The sacrifice ratio shows how many percentage points of RGDP

are lost when fighting inflation.

Sacrifice Ratio = Percentage Points of lost GDP

Percentage Points of lowered inflation

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Ex: For the US, the sacrifice ratio is estimated to be 5. If we
want to reduce inflation from 7% to 3%, then by how many
percentage points will GDP fall?

5= X .
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X = 20
GDP will decrease by 20 percentage points.

Reducing inflation that has gotten out of hand is very painful for
the economy!
- when RGDP falls, jobs are lost

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