CHAPTER 17

THE SHORT-RUN TRADEOFF BETWEEN

INFLATION AND UNEMPLOYMENT
Introduction
Introduces the Phillips Curve
Examines the theory and the historical record of
the tradeoff between inflation and unemployment
Explores the natural-rate hypothesis, sacrifice
ratio, and the theory of rational expectations.
The i!"r# ind"$
the rate of inflation added to the
unemployment rate
has been used as a measure of the health of the
economy.

1%-1 T&" P&i''i(! Cur)"

Ori*in! o+ t&" P&i''i(! Cur)"
In !"# $.%. Phillips showed that wa&e rates, which
move closely with inflation, were related to
unemployment.
$merican economists 'uic(ly confirmed a similar
findin& for the ).*.
In years with low unemployment the inflation rates
seems hi&h and in years with hi&h unemployment the
inflation rate is lower.
*ociety faces a tradeoff between inflation and
unemployment.
+
They reasoned that in periods of low unemployment
there was more a&&re&ate demand and therefore,
more intense pressure on wa&es and prices.
A**r"*,t" D",nd- A**r"*,t" Su(('#- ,nd t&"
P&i''i(! Cur)"
The Phillips curve simply shows the combinations of
inflation and unemployment that arise in the short run
as shifts in the a&&re&ate demand curve move the
economy alon& the a&&re&ate supply curve.
*ee ,i&ure --+.
*ince monetary and fiscal policy can move the
a&&re&ate demand curve, policyma(ers have a menu
of options to choose from when tryin& to ad.ust the
economy.
/
,or lower unemployment with hi&her inflation -
increase the money supply
increase &overnment spendin&
cut taxes
,or lower inflation with hi&her unemployment -
decrease the money supply
decrease &overnment spendin&
raise taxes
In t&" N".!/ T&" E++"ct! o+ Lo. Un"('o#"nt
This article demonstrates that ti&hter labor mar(ets
demand hi&her wa&es, illustratin& the principle
underlyin& the Phillips Curve.
0
1%-0 S&i+t! in t&" P&i''i(! Cur)"/ T&" Ro'" o+
E$("ct,tion!
T&" Lon*-Run P&i''i(! Cur)"
$ccordin& to Classical theory, the rate of money
&rowth determines inflation in the short-run but in the
lon& run has no impact on real variables.
,riedman, and Edmund Phelps, concluded that there
is no reason to thin( that the rate of inflation would
be related to the rate of unemployment in the lon&
run.
This implies that the lon&-run Phillips curve is
vertical at the natural rate of unemployment.
*ee ,i&ure --/.
"
*ince the 1natural1 rate of unemployment is simply
that rate to which the economy tends to move, it is
desirable to try to find ways to shift the lon&-run
Phillips curve to the left.
Policyma(ers should loo( to policies that improve the
functionin& of the labor mar(et.
Therefore, ,riedman concluded that monetary policy
could only be used in the short-run to pic( a point on
the Phillips curve.
-
E$("ct,tion! ,nd t&" S&ort-Run P&i''i(! Cur)"
To explain the short-run and lon&-run relationship
between inflation and unemployment, ,riedman and
Phelps introduced a new variable into the analysis2
"$("ct"d in+',tion.
Expected inflation measures how much people expect
the overall price level to chan&e.
3ecause perceptions, wa&es, and prices will
eventually ad.ust to the inflation rate, the lon&-run
a&&re&ate supply curve is vertical at the output level
associated with the natural rate of unemployment.
)nemployment rate 4
5atural 6ate of )nemployment
a 7$ctual inflation - Expected inflation8
9
,riedman ar&ued in the lon& run people come to
expect whatever inflation the ,ed actually produces.
Thus, actual inflation e'uals expected inflation, and
unemployment is at its natural rate.
,riedman and Phelps concluded that even if
policyma(ers did face a short-run tradeoff between
inflation and unemployment and had tools to address
one or the other, that they shouldn:t.
#
T&" N,tur,' E$("ri"nt +or t&" N,tur,'-R,t"
H#(ot&"!i!
The natural-rate hypothesis says that unemployment
eventually returns to its natural rate, re&ardless of the
rate of inflation.
The period from !9;-!9/ proved ,riedman and
Phelps:s theory was correct.
*ee ,i&ures --- and --9.
!
1%-1 T&" Ro'" o+ Su(('# S&oc2!
$fter the <PEC price increases resulted in
sta&flation, policyma(ers had to decide whether to
focus on reducin& unemployment or reducin&
inflation.
The <PEC supply shoc(s that shifted a&&re&ate
supply to the left forced policyma(ers to respond to
both hi&h unemployment and hi&h inflation.
Partly because of ,ed policy, we witnessed hi&h
inflation and moderate unemployment.
*ee ,i&ure --#.
;
1%-3 T&" Co!t o+ R"ducin* In+',tion
In !9!, ,ed chairman Paul =olc(er decided to
pursue a policy of disinflation.
The ,ed would follow a contractionary monetary
policy to try to reduce inflation.
The short-run impact would be an increase in
unemployment because of low output.
T&" S,cri+ic" R,tio
Definition of the sacrifice ratio - the number of
percenta&e points of annual output lost in the process
of reducin& inflation by percenta&e point.
$ typical estimate is ".

To try to decrease inflation by percent, you must be

willin& to sacrifice a five percent loss in output.
R,tion,' E$("ct,tion! ,nd t&" Po!!i4i'it# o+
Co!t'"!! Di!in+',tion
Definition of the theory of rational expectations -
people optimally use all available information,
includin& information about &overnment policy, when
formin& expectations.
The sacrifice ratio could be reduced if the
&overnment is resolute in its commitment to follow
the policy of inflation reduction consistently.
People would ad.ust their expectations 'uic(ly and
the pain of unemployment could be shortened.
+
T&" 5o'c2"r Di!in+',tion
%hile =olc(er was successful in reducin& inflation,
unemployment rose to about ; percent.
The =olc(er disinflation produced the deepest
recession in the )nited *tates since the >reat
?epression of the !/;s.
T&" 6r""n!(,n Er,
The period from !#0 to !!" be&an with a favorable
supply shoc( as oil prices fell.
This has fueled both fallin& inflation and fallin&
unemployment.
3ut durin& that time $lan >reenspan has remained
vi&ilant as an inflation fi&hter.
/
In t&" N".!/ Un"('o#"nt ,nd It! N,tur,'
R,t"
In !!-, the unemployment rate fell to ".@.
The ,ed had to decide if this was the natural rate or
not.
1%-7 Conc'u!ion
,riedman2
AThere is a temporary tradeoff between inflation
and unemploymentB
AThere is no permanent tradeoffB
0