In this chapter,

look for the answers to these questions

Principles of

• How are inflation and unemployment related in

Wojciech Gerson (1831-1901)

the short run? In the long run?
• What factors alter this relationship?
• What is the short-run cost of reducing inflation?
• Why were U.S. inflation and unemployment both
so low in the 1990s?

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Introduction The Phillips Curve

§ In the long run, inflation & unemployment are § Phillips curve : shows the short-run trade-off
unrelated: between inflation and unemployment
§ The inflation rate depends mainly on growth in § 1958: A.W. Phillips showed that
the money supply. nominal wage growth was negatively
§ Unemployment (the “natural rate”) depends on correlated with unemployment in the U.K.
the minimum wage, the market power of unions,
efficiency wages, and the process of job search. § 1960: Paul Samuelson & Robert Solow found
a negative correlation between U.S. inflation
§ One of the Ten Principles: & unemployment, named it “the Phillips Curve.”
In the short run, society faces a trade-off
between inflation and unemployment.

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Deriving the Phillips Curve Deriving the Phillips Curve

A. Low agg demand, low inflation, high u-rate
§ Suppose P = 100 this year.
P inflation
§ The following graphs show two possible
outcomes for next year: SRAS
A. Agg demand low, B B
5%
105
small increase in P (i.e., low inflation), A
low output, high unemployment. 103 3% A
AD2
B. Agg demand high, PC
AD1
big increase in P (i.e., high inflation),
high output, low unemployment. Y1 Y2 Y 4% 6% u-rate

B. High agg demand, high inflation, low u-rate

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1
 Evidence for the Phillips Curve?
The Phillips Curve: A Policy Menu?
Inflation rate
§ Since fiscal and mon policy affect agg demand, (% per year) During the 1960s,
the PC appeared to offer policymakers a menu U.S. policymakers
of choices: opted for reducing
§ low unemployment with high inflation unemployment
§ low inflation with high unemployment at the expense of
§ anything in between higher inflation
68
§ 1960s: U.S. data supported the Phillips curve.
66
Many believed the PC was stable and reliable. 67
62
65
1961
64 63

Unemployment
6
rate (%) 7
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The Vertical Long-Run Phillips Curve

The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes
§ 1968: Milton Friedman and Edmund Phelps faster inflation.
argued that the tradeoff was temporary. P inflation
LRAS LRPC
§ Natural-rate hypothesis : the claim that
high
unemployment eventually returns to its normal or P2
infla-
“natural” rate, regardless of the inflation rate tion
§ Based on the classical dichotomy and the P1 AD2 low
vertical LRAS curve
infla-
AD1 tion

Y u-rate
Natural rate Natural rate of
of output unemployment
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Reconciling Theory and Evidence The Phillips Curve Equation

Natural
Unemp.
§ Evidence (from ’60s): = rate of – a Actual – Expected
PC slopes downward. rate inflation inflation
unemp.
§ Theory (Friedman and Phelps):
PC is vertical in the long run. Short run
Fed can reduce u-rate below the natural u-rate
§ To bridge the gap between theory and evidence, by making inflation greater than expected.
Friedman and Phelps introduced a new variable:
Long run
expected inflation – a measure of how much
Expectations catch up to reality,
people expect the price level to change. u-rate goes back to natural u-rate whether inflation is
high or low.

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2
 How Expected Inflation Shifts the PC ACTIVE LEARNING 1
Initially, expected &
A numerical example
actual inflation = 3%, Natural rate of unemployment = 5%
inflation
unemployment = LRPC Expected inflation = 2%
natural rate (6%).
In PC equation, a = 0.5
Fed makes inflation
B C A. Plot the long-run Phillips curve.
2% higher than expected, 5%
u-rate falls to 4%. B. Find the u-rate for each of these values of actual
In the long run, 3% A inflation: 0%, 6%. Sketch the short-run PC.
expected inflation PC2 C. Suppose expected inflation rises to 4%.
increases to 5%, PC1 Repeat part B.
PC shifts upward, D. Instead, suppose the natural rate falls to 4%.
4% 6% u-rate
unemployment returns to
Draw the new long-run Phillips curve,
its natural rate.
12
then repeat part B.
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ACTIVE LEARNING 1 The Breakdown of the Phillips Curve

LRPC D
Answers
PCB LRPC A Inflation rate
7 (% per year) Early 1970s:
An increase
in expected 6 unemployment increased,
inflation Friedman &
despite higher inflation.
5 Phelps’
shifts PC to
inflation rate

the right. 4 explanation:

PCD 73 expectations
3 69 71
70 were catching
PCC 68
A fall in the 2 72 up with reality.
66
natural rate 67
62
1
shifts both 65
1961
64 63
curves 0
to the left. 0 1 2 3 4 5 6 7 8 Unemployment
unemployment rate
rate (%) 15
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How an Adverse Supply Shock Shifts the PC

Another PC Shifter: Supply Shocks
SRAS shifts left, prices rise, output & employment fall.
§ Supply shock :
P inflation
an event that directly alters firms’ costs and
prices, shifting the AS and PC curves SRAS 2

§ Example: large increase in oil prices SRAS 1

B B
P2

P1 A A
PC2

AD PC1
Y2 Y1 Y u-rate

Inflation & u-rate both increase as the PC shifts upward.

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3
 The 1970s Oil Price Shocks The 1970s Oil Price Shocks
Oil price per barrel The Fed chose to Inflation rate
accommodate the (% per year) Supply
1/1973 $ 3.56 shocks &
first shock in 1973 81 75
1/1974 10.11 rising
with faster money growth. 74
1/1979 14.85 79
80 expected
Result: 78 inflation
1/1980 32.50 Higher expected inflation, 77 worsened
1/1981 38.00 which further shifted PC. 73
76 the PC
1979: 1972 tradeoff.
Oil prices surged again,
worsening the Fed’s tradeoff.

Unemployment
18
rate (%) 19
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The Cost of Reducing Inflation Disinflationary Monetary Policy

Contractionary monetary
§ Disinflation: a reduction in the inflation rate policy moves economy inflation
§ To reduce inflation, from A to B. LRPC
Fed must slow the rate of money growth, Over time,
A
which reduces agg demand. expected inflation falls,
PC shifts downward.
§ Short run: B
Output falls and unemployment rises. In the long run, C
point C: PC1
§ Long run: the natural rate PC2
Output & unemployment return to their natural of unemployment,
rates. lower inflation. u-rate
natural rate of
unemployment
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The Cost of Reducing Inflation Rational Expectations, Costless Disinflation?

§ Disinflation requires enduring a period of
high unemployment and low output. § Rational expectations : a theory according to
which people optimally use all the information
§ Sacrifice ratio :
percentage points of annual output lost they have, including info about govt policies,
per 1 percentage point reduction in inflation when forecasting the future
§ Typical estimate of the sacrifice ratio: 5 § Early proponents:
§ To reduce inflation rate 1%, Robert Lucas, Thomas Sargent, Robert Barro
must sacrifice 5% of a year’s output. § Implied that disinflation could be much less
§ Can spread cost over time, e.g. costly…
To reduce inflation by 6%, can either
§ sacrifice 30% of GDP for one year
§ sacrifice 10% of GDP for three years 22 23
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4
 Rational Expectations, Costless Disinflation? The Volcker Disinflation
§ Suppose the Fed convinces everyone it is Fed Chairman Paul Volcker
committed to reducing inflation. § Appointed in late 1979 under high inflation &
unemployment
§ Then, expected inflation falls,
the short-run PC shifts downward. § Changed Fed policy to disinflation

§ Result: 1981–1984:
Disinflations can cause less unemployment § Fiscal policy was expansionary,
than the traditional sacrifice ratio predicts. so Fed policy had to be very contractionary
to reduce inflation.
§ Success: Inflation fell from 10% to 4%,
but at the cost of high unemployment…

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The Volcker Disinflation

The Greenspan Era
Inflation rate Disinflation turned out to be very costly § 1986: Oil prices fell 50%.
(% per year)
§ 1989 –90:
81 u-rate
80 Unemployment fell, inflation rose.
near 10%
1979 Fed raised interest rates, caused a
in 1982 –83
mild recession.
82
§ 1990s:
84 Unemployment and inflation fell.
83
87 85 § 2001: Negative demand shocks
86
created the first recession in a decade.
Policymakers responded with expansionary monetary
Unemployment and fiscal policy.
rate (%) 26 27
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The Greenspan Era The Phillips Curve During the

Financial Crisis
Inflation rate
(% per year) Inflation and unemployment
§ The early 2000s housing market
were low during most of
boom turned to bust in 2006
Alan Greenspan’s years
as Fed Chairman. § Household wealth fell,
millions of mortgage defaults
90
and foreclosures, heavy losses
Ben Bernanke
05 at financial institutions Chair of FOMC,
06 1987
§ Result: Feb 2006 – Jan 2014
2000 92

98 96 02 94
Sharp drop in aggregate demand,
steep rise in unemployment
Unemployment
rate (%) 28 29
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5
 The Phillips Curve During and
after the Financial Crisis CONCLUSION
Inflation rate
(% per year) § The theories in this chapter come from some of
2006-2009:
the greatest economists of the 20 th century.
The financial crisis caused aggregate
demand to plummet, sharply increasing
2010-2012: § They teach us that inflation and unemployment
unemployment andreduced
A slow recovery reducing inflation. are:
unemployment and increased inflation. § unrelated in the long run
§ negatively related in the short run
2006 § affected by expectations,
2012
2007 2011 which play an important role in the economy’s
2008
2010 adjustment from the short-run to the long run
2009

Unemployment
rate (%) 30 31
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Summary Summary

• The Phillips curve describes the short-run • The Fed can reduce inflation by contracting the
tradeoff between inflation and unemployment. money supply, which moves the economy along
• In the long run, there is no tradeoff: its short-run Phillips curve and raises
inflation is determined by money growth, unemployment. In the long run, though,
while unemployment equals its natural rate. expectations adjust and unemployment returns
to its natural rate.
• Supply shocks and changes in expected inflation
shift the short-run Phillips curve, making the • Some economists argue that a credible
tradeoff more or less favorable. commitment to reducing inflation can lower the
costs of disinflation by inducing a rapid
adjustment of expectations.

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