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Learning Objectives
I. Goals of Part 4
A. How macroeconomic policy works and how it can best be used
1. Unemployment and inflation (this chapter)
2. Policy in an open economy—international trade and finance (Ch. 13)
3. Monetary institutions and policy (Ch. 14)
4. Fiscal institutions and policy (Ch. 15)
Teaching Notes
I. Unemployment and Inflation: Is There a Trade-off? (Sec. 12.1)
A. Many people think there is a trade-off between inflation and unemployment
1. The idea originated in 1958 when A.W. Phillips showed a negative relationship between
unemployment and nominal wage growth in Britain
2. Since then economists have looked at the relationship between unemployment and inflation
3. In the 1950s and 1960s many nations seemed to have a negative relationship between the
two variables
4. The United States appears to be on one Phillips curve in the 1960s (text Figure 12.1)
5. This suggested that policymakers could choose the combination of unemployment and
inflation they most desired
6. But the relationship fell apart in the following three decades (text Figure 12.2)
7. The 1970s were a particularly bad period, with both high inflation and high unemployment,
inconsistent with the Phillips curve
B. The expectations-augmented Phillips curve
1. Friedman and Phelps: The cyclical unemployment rate (the difference between actual and
natural unemployment rates) depends only on unanticipated inflation (the difference between
actual and expected inflation)
a. This theory was made before the Phillips curve began breaking down in the 1970s
b. It suggests that the relationship between inflation and the unemployment rate isn’t stable
2. How does this work in the extended classical model?
a. First case: anticipated increase in money supply (Figure 12.1; like text Figure 12.3)
Figure 12.1
Figure 12.2
(1) AD expected to shift up to AD2, old (money supply expected to rise 10%), but
unexpectedly money supply rises 15%, so AD shifts further up to AD2, new
(2) SRAS shifts up based on expected 10% rise in money supply
(3) Result: P rises and Y rises as misperceptions occur
(4) So higher inflation occurs with lower unemployment
Numerical Problems 1 and 3 and Analytical Problem 2 look at the misperceptions model and how
it generates behavior like the Phillips curve.
Figure 12.3
a. For a given expected rate of inflation, the short-run Phillips curve shows the trade-off
between cyclical unemployment and actual inflation
b. The short-run Phillips curve is drawn such that e when u u
c. Higher expected inflation implies a higher short-run Phillips curve
3. Changes in the natural rate of unemployment (Figure 12.4; like text Figure 12.6)
Figure 12.4
a. For a given natural rate of unemployment, the short-run Phillips curve shows the trade-off
between unemployment and unanticipated inflation
Analytical Problem 1 looks at possible ways to change the natural rate of unemployment.
b. A higher natural rate of unemployment shifts the short-run Phillips curve to the right
4. Supply shocks and the Phillips curve
a. A supply shock increases both expected inflation and the natural rate of unemployment
(1) A supply shock in the classical model increases the natural rate of unemployment,
because it increases the mismatch between firms and workers
(2) A supply shock in the Keynesian model reduces the marginal product of labor and
thus reduces labor demand at the fixed real wage, so the natural unemployment
rate rises
b. So an adverse supply shock shifts the short-run Phillips curve up and to the right
c. The short-run Phillips curve will be unstable in periods with many supply shocks
Numerical Problem 2 looks at the effects of an aggregate demand shock and an aggregate supply
shock on the short-run Phillips curve.
Policy Application
The theory of rational expectations explains why the Phillips curve trade-off appeared to be stable
for some time, but failed when policymakers tried to exploit it. In the 1960s people assumed that
any rise in inflation would be temporary. But once policymakers began to exploit the trade-off,
people caught on quickly. Instead of having adaptive expectations, which were rational in the
past, people began to watch what policymakers were doing. Then expected inflation changed
quickly with changes in policy.
Theoretical Application
The Keynesian models of the early 1970s assumed that people formed adaptive expectations, that
is, that expected inflation depended only on past inflation, so te f (t 1, t 2, . . .). According to
rational expectations theory, however, people base their inflation expectations on an economic
model in which inflation depends on other variables, such as the growth rate of the money
supply, the state of the economy, and expectations of future government deficits. Adaptive
expectations could be rational, as in the 1950s and 1960s, because an economic model would
suggest a simple time-series process for inflation. But once the Fed began using monetary policy
for countercyclical policy, or for trying to exploit the Phillips curve, adaptive expectations
became irrational. With rational expectations, people began to anticipate changes in monetary
policy, and the Phillips curve began to shift with changes in policy.
Figure 12.5
3. Changes in the level of money supply have no long-run real effects; changes in the growth
rate of money supply have no long-run real effects, either
4. Even though expansionary policy may reduce unemployment only temporarily, policymakers
may want to do so if, for example, timing economic booms right before elections helps them
(or their political allies) get reelected
Theoretical Application
For a well written history of the Phillips curve and its usefulness, see the article by Robert J.
Gordon, “The Phillips Curve Now and Then,” National Bureau of Economic Research Working
Paper No. 3393, June 1990. For more recent research on the Phillips curve, see the symposium in
the Journal of Money, Credit, and Banking 39 (supplement, Feb. 2007).
Data Application
Recent research suggests that the costs of unemployment to individual workers may be higher if they
become unemployed at the same time as many other people. Research by Stephen J. Davis and Till M.
von Wachter, “Recessions and the Cost of Job Loss,” Brookings Papers on Economic Activity, Fall
2011, pp. 1-72, shows that people who are laid off in periods when the overall unemployment rate is
6% or less lose about 1.4 years’ worth of earnings; but those laid off in periods when the overall
unemployment rate is above 8% lose twice as much, on average.
of unemployment
d. Some economists think the natural rate of unemployment was 4.5% or even lower in the
1990s and 2000s
(1) The labor market became more efficient at matching workers and jobs, reducing
frictional and structural unemployment
(2) Temporary help agencies became prominent, helping the matching process and
reducing the natural rate of unemployment
f. Increased labor productivity may increase the natural rate of unemployment
(1) If increases in real wages lag changes in productivity, firms hire more workers and
the natural rate of unemployment will decline temporarily
(2) Ball and Mankiw found evidence supporting this hypothesis in the 1990s
Data Application
A very different picture of the natural rate of unemployment than that of the CBO comes from
classical economists, who think the natural rate changes much more than the CBO’s measure does.
One version of this can be found in the article “In Search of the Natural Rate of Unemployment,”
by Thomas B. King and James Morley, Journal of Monetary Economics (2007), pp. 550–564.
Analytical Problem 6 looks at events that change the natural rate of unemployment.
Analytical Problem 4 looks at the costs of anticipated and unanticipated inflation in a cashless
society.
Policy Application
Shoe-leather costs are generated by people’s attempt to reduce how much cash they hold.
Implicitly, inflation is like a tax on people’s cash holdings, because the government buys things
with newly printed money (just like it could if it collected taxes to pay for them) and people who
hold cash lose purchasing power (just as if their money was taxed). Some economists have gone
so far as to suggest that using the inflation tax is beneficial to the economy, because much of the
burden is borne by people in the underground economy and foreigners who use U.S. dollars. See
S. Rao Aiyagari, “Deflating the Case for Zero Inflation,” Federal Reserve Bank of Minneapolis
Quarterly Review, Summer 1990.
Policy Application
Two other costs of anticipated inflation are increased taxation on capital income and the
mortgage-tilt problem.
Because taxes are based on the dollar value of interest that savers receive, the higher the
inflation rate is, the larger is the government’s tax revenue as a proportion of a saver’s real
return. The increase in the government’s effective real tax rate represents a distortion to the
economy—higher anticipated inflation reduces saving and investment.
Another cost of perfectly anticipated inflation is the problem of “tilting” the real value of loan
payments over time. To see this, suppose inflation were zero and you borrowed $100,000 to buy a
house, repaying the mortgage loan over 30 years. At an interest rate of 5% per year, your monthly
mortgage payment would be $540. In real (inflation-adjusted) terms, the payment would be the
same over time. But if the inflation rate were 5% per year and the mortgage interest rate were
10% per year, your monthly payment would be $880. In real terms, the value of the monthly
payment would be very high initially but decline steadily over time. The real value of your final
payment would be just 23% of your initial payment. (The value of a dollar payment made
30 years in the future at an interest rate of 5% is given by the formula 1/1.0530 $0.23.) A graph
of the real payment amount tilts downward, so this phenomenon is often referred to as the
mortgage-tilt problem. The tilt is greater, the higher is the inflation rate. Because of the
mortgage-tilt problem, homeowners face higher real payments early in the lives of their loans,
when they can probably least afford it, and they may face difficulties getting approved for
mortgages because the initial payment is a larger fraction of their household income. Thus,
anticipated inflation reduces homeownership. (For more discussion of the mortgage-tilt problem
and an estimate of the benefits to eliminating the problem by reducing inflation to zero, see
Dean Croushore, “What Are the Costs of Disinflation?” Business Review, Federal Reserve
Bank of Philadelphia, May/June 1992, pp. 3–16.)
2. Unanticipated inflation ( e)
a. Realized real returns differ from expected real returns
(1) Expected r i e
(2) Actual r i
(3) Actual r differs from expected r by e –
(4) Numerical example: i 6%, e 4%, so expected r 2%; if 6%, actual
r 0%; if 2%, actual r 4%
b. Similar effect on wages and salaries
c. Result: transfer of wealth
(1) From lenders to borrowers when e
(2) From borrowers to lenders when e
Data Application
Since the inflation of the mid-1970 was a surprise to people, it led to a large transfer of wealth.
The biggest winners in the 1970s were homeowners who owned land (which appreciated in value
with inflation) and had fixed-rate mortgages (whose value fell with inflation). The biggest losers
were the wealthy who owned stocks and bonds, as real returns fell dramatically because of
inflation.
Data Application
In my article, “Inflation Forecasts: How Good Are They?” (Federal Reserve Bank of Philadelphia
Business Review, May/June 1996), I examine tests of bias in the inflation forecasts of both
consumers and professional forecasters. The forecasts looked very bad in the 1970s, probably
because of the two big oil price shocks in that period. Since then, the forecasts have been very
good, suggesting that the forecasts are formed rationally.
Policy Application
It’s difficult to figure out how to index wages to inflation, or how low inflation should be, when
inflation isn’t measured very well. For an interesting discussion of the issues and implications of
mismeasurement of inflation, see the symposium on “Measuring the CPI” in the Journal of
Economic Perspectives, Winter 1998.
Data Application
For a review of the empirical evidence on the costs of inflation, see the article by John Driffill,
Grayham E. Mizon, and Alistair Ulph, “Costs of Inflation,” in B. M. Friedman and F. H. Hahn,
eds., Handbook of Monetary Economics, vol. II, Amsterdam: Elsevier Science Publishers, 1990,
pp. 1013–1066.
Data Application
There are many wonderful stories one can tell to illustrate the problems that arise in
hyperinflations. For example, there’s the story about the person who goes to the bank with a
wheelbarrow full of money, but can’t get the wheelbarrow through the bank’s door. He goes
inside to get help and when he returns, the money is still there but the wheelbarrow has been
stolen. There’s also the mind-boggling size of the Hyperinflation figures. For example, in
Hungary between August 1945 and July 1946, the purchasing power of a unit of money fell
by a factor of 4 octillion! That’s 4,000,000,000,000,000,000,000,000,000.
Policy Application
Given the costs of inflation and the vertical long-run Phillips curve, what is the optimal rate of
inflation? Some economists suggest that the optimal rate of inflation is zero or even negative
(so that the nominal rate of interest is zero). See the discussion by Michelle R. Garfinkel, “What
Is an ‘Acceptable’ Rate of Inflation? A Review of the Issues,” Federal Reserve Bank of St. Louis
Review, July/August 1989. pp. 3–16. The debate over the pursuit of zero inflation reached its
peak in 1990 in the United States and Canada. Two conferences reflecting research on zero
inflation were held in Canada; see Zero Inflation: The Goal of Price Stability, Richard G. Lipsey,
ed., and Taking Aim: The Debate on Zero Inflation, Robert C. York, ed., both published by the
C.D. Howe Institute, Ottawa, Ontario, 1990. Canada’s central bank adopted a target of zero
inflation in the early 1990s.
Data Application
There are many problems with price indexes; they are imperfect measures of price changes. What
do the indexes do when new goods are introduced? What happens as more efficient stores replace
stores that had higher intermediate costs? How do we account for the fact that people substitute
cheaper goods for higher-priced goods? Inadequate treatment of these questions means the
measures of prices give an overestimate of the inflation rate of 0% to 2%. So a measured
inflation rate of 1% might really mean that the true average price level is constant. See David E.
Lebow, John M. Roberts, and David J. Stockton, “Understanding the Goal of Price Stability,”
Working Paper No. 125, Economic Activity Section, Board of Governors of the Federal Reserve
System, April 1992.
C. The costs of disinflation could be reduced if expected inflation fell at the same time actual
inflation fell
D. Rapid versus gradual disinflation
1. The classical prescription for disinflation is cold turkey—a rapid and decisive reduction in
money growth
a. Proponents argue that the economy will adjust fairly quickly, with low costs of
adjustment, if the policy is announced well in advance
b. Keynesians disagree
(1) Price stickiness due to menu costs and wage stickiness due to labor contracts make
adjustment slow
(2) Cold turkey disinflation would cause a major recession
(3) The strategy might fail to alter inflation expectations, because if the costs of the
policy are high (because the economy goes into recession), the government will
reverse the policy
Data Application
Tom Sargent (“The Ends of Four Big Inflations”) suggests that high rates of inflation may be
reduced quickly with little output loss if a country creates an independent central bank and
changes its fiscal policy to eliminate government budged deficits. Robert Gordon (“Why
Stopping Inflation May Be Costly: Evidence from Fourteen Historical Episodes”) suggests that
there have been very few disinflation episodes without substantial output loss; most recent
disinflations have been accompanied by substantial recessions. See their articles in Robert
E. Hall, ed., Inflation: Causes and Effects, Chicago: University of Chicago Press, 1982.
Policy Application
In the late 1980s the Federal Reserve embarked on an attempt at gradualism, at least in their
stated ranges for the M2 monetary aggregate. The Fed lowered the growth range for M2 by
roughly ½ percentage point each year from 1986 to 1994.
b. Such a strategy will be politically sustainable because the costs are low
Data Application
In my article “What Are the Costs of Disinflation?” Federal Reserve Bank of Philadelphia
Business Review, May/June 1992, pp. 3–16, I examine the costs to the economy of reducing
inflation from its existing rate to zero in a variety of models: a Keynesian model, a Monetarist
model, a classical (misperceptions) model, and a hybrid model. The costs of disinflation are
found to be substantially smaller than the benefits in all but the Keynesian model.
c. Ball also found a lower sacrifice ratio from cold turkey disinflation than from
gradualism
4. Ball’s results should be interpreted with caution, since it isn’t easy to calculate the loss
of output and because supply shocks can distort the calculation of the sacrifice ratio
Data Application
A version of Ball’s article that is accessible to students is “How Costly Is Disinflation? The
Historical Evidence,” Federal Reserve Bank of Philadelphia Business Review,
November/December 1993, pp. 17–28.
Analytical Problem 5 looks at what happens if the government uses wage and price controls, but
continues to use expansionary policies.
4. The Nixon wage-price controls from August 1971 to April 1974 led to shortages in many
products; the controls reduced inflation when they were in effect, but prices returned to
where they would have been soon after the controls were lifted
G. Credibility and reputation
1. Key determinant of the costs of disinflation: how quickly expected inflation adjusts
2. This depends on credibility of disinflation policy; if people believe the government and if
the government carries through with its policy, expected inflation should drop rapidly
3. Credibility can be enhanced if the government gets a reputation for carrying out its
promises
4. Also, having a strong and independent central bank that is committed to low inflation
provides credibility
H. The U.S. disinflation of the 1980s and 1990s
1. Fed chairmen Volcker and Greenspan gradually reduced the inflation rate in the 1980s and
1990s
a. They sought to eliminate inflation as a source of economic instability
b. They wanted people to be confident that inflation would never be very high again
2. To judge the Fed’s success, we look at inflation expectations (text Fig. 12.10)
a. Inflation expectations were erratic before 1990
b. Inflation expectations fell gradually from 1990 to 1998 and have been stable since then
3. Inflation expectations were slow to decline initially (in the late 1970s and early 1980s)
because Volcker and the Fed lacked credibility
4. But as inflation continued to fall, the Fed’s credibility increased, and inflation expectations
declined gradually
5. To solidify those expectations, the Fed declared a 2% long-run inflation target in 2012
Data Application
In the severe recession that began in December 2007 and was precipitated by the housing crisis,
inflation declined substantially. Some analysts thought that inflation fell mainly because of the
decline in housing prices. However, as economists at the Federal Reserve Bank of San Francisco
note (see Bart Hobijn, Stefano Eusepi, and Andrea Tambalotti, “The Housing Drag on Core
Inflation,” Federal Reserve Bank of San Francisco Economic Letter, 2010–11, April 5, 2010,
available online at: www.frbsf.org/publications/economics/letter/2010/el2010-11.pdf), this was not
the case; instead, prices of most goods and services stopped growing as rapidly as before. Core
inflation including housing prices does not differ much from core inflation excluding housing
prices.
Here’s a numerical example. Consider a $100,000, 30-year mortgage. In case A inflation is 0% and the
nominal interest rate is 5%. The monthly payment is $540, the real value of which is constant over time.
Using the 28% rule used by lenders today (that a person’s mortgage payment shouldn’t exceed 28% of
income), a person would have to have income of $23,000 to qualify for the mortgage. In case B inflation is
5% and the nominal interest rate is 10%. The monthly payment on the mortgage is $880. But this amount
declines steadily over time in real terms because of inflation. The income needed to qualify for the mortgage
is $37,000. So in case B with higher inflation, the initial monthly payment is higher and the income needed
to qualify for the loan is higher, so inflation discourages homeownership. (Again, the result wouldn’t be so
dramatic except for some simplifications; the 28% rule might become a higher number if inflation were
lower.) There is a potential solution to this problem, which is the introduction of a price-level-adjusted
mortgage (PLAM); but PLAMs haven’t yet been adopted by financial institutions.
2. In the original Phillips curve, inflation itself is related to the unemployment rate. In the expectations-
augmented Phillips curve, it is unanticipated inflation (the difference between actual
and expected inflation) that is related to cyclical unemployment (the difference between the
unemployment rate and the natural rate of unemployment). The short-run Phillips curve appears in
the data at times when both expected inflation and the natural rate of unemployment are fixed.
3. In the early 1960s the rate of inflation was fairly low (about 1% to 2%), and it didn’t vary much from
year to year. But supply shocks hit the economy in both the mid- and the late-1970s, causing a rise in
expected inflation and an upward shift in the Phillips curve. Expansionary monetary and fiscal
policies kept inflation high in the 1970s until the Federal Reserve began pursuing contractionary
monetary policy to reduce inflation during 1979–1982. This moved the economy to a lower Phillips
curve, which was maintained in the 1980s. The instability of the Phillips curve is largely because of
higher expected inflation associated with supply shocks in the 1970s.
4. According to the classical point of view, the economy adjusts quickly to changes in inflation, so there
is only a very short period in which unemployment changes because of a change in inflation. Further,
any systematic attempt to reduce unemployment by increasing inflation would be fully anticipated,
and would have no effect on unemployment.
Keynesians believe, however, that there is a temporary trade-off between unemployment and
inflation. If policymakers want to, they can increase inflation to reduce unemployment in the short
run. However, the economy must return to the natural rate of unemployment in the long run, so the
reduction in unemployment is only temporary.
5. Policymakers want to keep inflation low because inflation imposes costs on the economy. Costs of
anticipated inflation include shoe leather costs and menu costs. Costs of unanticipated inflation
include unpredictable transfers of wealth between lenders and borrowers, resources used to reduce the
risk of such transfers, and reduced efficiency because of the difficulty in observing relative prices.
When there is cyclical unemployment, society as a whole loses because of output that is not produced
and the families of the unemployed suffer personal and psychological costs.
6. The natural rate of unemployment is the rate of unemployment that exists when output is at its full-
employment level. This occurs when the only unemployment is frictional and structural, not cyclical.
The natural rate is crucial in understanding the Phillips curve.
The natural rate of unemployment has moved higher over time in the United States and Europe due to
a number of factors. First, demographic changes occurred that raised the natural rate. Groups in the
labor force that have higher rates of unemployment have increased in size relative to groups that have
lower rates of unemployment. Also, there have been structural changes in the economy that may have
raised the natural rate in the 1970s. In Europe, hysteresis has kept the unemployment rate from
declining much after it hit very high levels in the early 1980s. Hysteresis arises because of
government regulation and bureaucratic aspects of firms and labor unions, and due to insiders
keeping outsiders from gaining employment.
To reduce the natural rate of unemployment, the government could support job training and worker
relocation, reduce regulations to increase labor market flexibility, reform unemployment insurance, or
create a high-pressure economy.
7. Two costs of anticipated inflation are shoe-leather costs and menu costs. Two costs of unanticipated
inflation are transfers of wealth and confusion of price signals.
If the economy experiences hyperinflation, shoe-leather costs become very large as people try to
minimize their cash holdings. Also, prices change so frequently they cease to serve as signals. Menu
costs do not rise too much, as firms simply quote prices in terms of some other unit of account
(a different country’s currency). Transfers of wealth also occur, especially since the government
loses tax revenue as people delay paying taxes.
8. The greatest potential cost of disinflation is that it may cause a recession. This occurs because
inflation may fall below expected inflation, causing the unemployment rate to rise along
the Phillips curve.
However, if the public anticipates the disinflation, expected inflation will adjust quickly and the costs
of disinflation will be low.
9. One approach to disinflation is a cold turkey strategy. It has the advantage of reducing inflation
quickly, but it may have high costs from increasing unemployment, according to Keynesians.
So, Keynesians suggest a gradualist policy to reduce inflation more slowly but with less rise in
unemployment. This also has the advantage of being politically sustainable, since policymakers
are less likely to back off from disinflation.
10. The Federal Reserve works hard to establish its credibility so that the costs of reducing inflation
will be low. If the Federal Reserve has a great deal of credibility, then people will believe that the
inflation rate will not rise in the future, so the expected inflation rate will be low and stable. The
sacrifice ratio will also be low, so the costs of disinflation will be reduced.
Numerical Problems
1. (a) Equating aggregate demand to short-run aggregate supply gives: 300 10(M/P) 500 P Pe,
or 300 (10 1000/P) 500 P 50, or 10,000/P 150 P. Multiplying both sides of the
equation by P and rearranging gives P2 150P 10,000 0, which can be factored as (P 50)
(P 200) 0. This has the nonnegative solution P 50. Since Pe is also 50, the expected price
level equals the actual price level, so output is at its full-employment level of 500 and the
unemployment rate is at the natural rate of 6%. These are the long-run equilibrium values of
the three variables as well.
(b) When the nominal money supply increases unexpectedly to 1260, we again equate aggregate
demand to short-run aggregate supply, which gives: 300 10(M/P) 500 P Pe, or 300
(10 1260/P) 500 P 50, or 12,600/P 150 P. Multiplying both sides of the equation by
P and rearranging gives P2 150P 12,600 0, which can be factored as (P 60)(P 210) 0.
This has the nonnegative solution P 60. When P 60, the short-run aggregate supply curve
gives Y 500 P Pe 500 60 50 510. Output of 510 is 2% above full-employment
output of 500, because (510 500)/500 0.02. With a natural unemployment rate of 0.06,
Okun’s Law gives 0.02 2(u 0.06). This can be solved to get u 0.05.
In the long run, Pe adjusts to equal P, output adjusts to its full-employment level of 500, and
unemployment adjusts to the natural rate of 0.06. To find P, use the aggregate demand curve
to get 500 300 10(1260/P), or 200 12,600/P, which can be solved to get P 63.
The results of this exercise are consistent with the existence of an expectations-augmented
Phillips curve. Unexpected inflation reduces unemployment in the short run. In the long run,
however, inflation is higher and unemployment returns to its natural rate.
2. (a) 0.10 2(u 0.06) 0.22 2u. This is shown as the Phillips curve labeled PCa in Figure 12.6.
If the Fed keeps inflation at 0.10, then u 0.06, the natural rate of unemployment.
Figure 12.6
(b) With expected inflation rising to 12%, the Phillips curve is 0.12 – 2(u – 0.06) 0.24 – 2u.
This is the Phillips curve labeled PC b in the figure. The higher rate of expected inflation has
caused the curve to shift up relative to where it was in part (a). With the actual inflation rate at
10%, the Phillips curve equation is 0.10 0.12 – 2(u – 0.06), which has the solution u 0.07.
So if the Fed tries to maintain the existing rate of inflation after a shock has raised inflation
expectations, the unemployment rate increases. However, if the Fed could convince people that
the inflation rate really would not rise, so that e remains at 0.10, then the short-run Phillips
curve would remain at PC a, and the unemployment rate would not increase.
(c) With the natural rate of unemployment rising to 0.08 at the same time that expected inflation
rises to 0.12, the Phillips curve equation is 0.12 2(u 0.08) 0.28 2u. This is the Phillips
curve labeled PC c in the figure. The new short-run Phillips curve is even higher than those for
parts (a) and (b). With the actual inflation rate held to 10%, the equation becomes 0.10 0.28 2u,
which can be solved to get u 0.09. The unemployment rate rises both because the Fed holds
inflation below expected inflation and because the natural rate has increased.
This time, even if the Fed convinced people that inflation would remain just 10%, the
unemployment rate would still rise to 8%, since the natural rate has increased to that level.
3. (a) Beginning in long-run equilibrium, with M 4000, output must be at its full-employment level
of 6000 and the unemployment rate must be equal to the natural rate of .05. Using the values for
Y and M in the AD curve, 6000 4000 2(4000/P), which gives P 4. This is also the expected
price level. Because M has been constant for a long time and is expected to remain constant,
e 0.
(b) With P e 4, the SRAS curve is Y 6000 100(P 4). The AD curve is Y 4000 2(4488/P).
The intersection of the two curves occurs when 6000 100(P 4) 4000 2(4488/P).
Simplifying terms gives 100P2 1600P 8976 0, which has the solution P 4.4. Plugging this
into the SRAS curve gives Y 6040. From the Okun’s Law equation we get (6040 6000)/6000
2 (u 0.05), so – 0.00333 u 0.05, so u .0467. Cyclical unemployment is u u
0.0033. Unanticipated inflation is (P Pe)/Pe 0.10 10%.
(c) The Phillips curve equation is e h(u u ), which gives .10 0 h(.0467 0.05).
This is solved to get h 30. So the slope of the Phillips curve is 30.
4. Since the natural rate of unemployment is 0.06, e 2(u 0.06), so u 0.06 0.5( e ),
or u 0.06 0.5( e ).
(a) Year 1: u 0.06 0.5(0.08 0.04) 0.06 0.02 0.08. The unemployment rate is 0.02 higher
than the natural rate. The percentage that output falls short of full-employment output is
2 0.02 0.04, or 4%.
Year 2: u 0.06 0.5(0.04 0.04) 0.06. The unemployment rate equals the natural rate, since
inflation equals expected inflation. Since unemployment is at its natural rate, output is at its
full-employment level.
Since the output loss was 4 percentage points and inflation declined by 8 percentage points, the
sacrifice ratio is 4/8 0.5.
(b) Use equations: u 0.06 0.5( e – ), output shortfall 2 (u – 0.06).
Analytical Problems
1. (a) The reduction in structural unemployment would reduce the natural rate of unemployment and
thus would shift both the expectations-augmented Phillips curve and the long-run Phillips curve
to the left.
(b) Despite the expense of the government program to reduce structural unemployment, it would
have a permanent effect. Monetary expansion can work only temporarily—in the long run it
has no effect.
2. The slope of the short-run aggregate supply curve will be much steeper in economy B, because
producers increase their output only a small amount in response to an increase in price. But economy
A’s short-run aggregate supply curve will be flatter, as people are likely to perceive price changes as
changes in relative price rather than the aggregate price level, and thus will respond more strongly to
changes in prices.
The short-run Phillips curve will also be steeper in economy B, since unemployment, like output,
won’t respond much to a change in inflation. But in economy A, unemployment and output will
respond more strongly to price changes, and the short-run Phillips curve will be flatter.
3. (a) In Figure 12.7, the SRAS curve shifts up 10% each year, as does the AD curve. Unanticipated
inflation is zero, as both actual and expected inflation are 10%. The economy is at full employment,
since firms set their prices to exactly match the increase in the general price level.
Figure 12.7
(b) The surprise increase in the money supply at mid-year leads to a rise in output, as shown in
Figure 12.8 by the shift of the AD curve from AD1 to AD2. Firms don’t adjust their prices, so the
SRAS curve remains fixed at SRAS1. When the money supply rises by its regular 10% at the end
of the year, the AD curve shifts up to AD3 and firms raise their prices by 15%, shifting the SRAS
curve up to SRAS3. Actual inflation is 15%, but expected inflation was only 10%. As a result,
there was a temporary increase in output above its full-employment level, and a temporary
decline in unemployment below the natural rate. Thus for the year as a whole, cyclical
unemployment was negative and unanticipated inflation was positive, just as in the expectations-
augmented Phillips curve.
Figure 12.8
4. In the cashless society, there would be no shoe-leather costs, as there would be no cash balances
on which to economize. But menu costs would remain for anticipated inflation. The costs of
unanticipated inflation would remain as well: both the risk of wealth transfers plus confusion
in price signals.
5. (a) Figure 12.9 shows the effects of increasing the money supply while holding the price level
constant. Beginning at point A, the intersection of aggregate demand curve AD1 and short-run
aggregate supply curve SRAS1, the increase in the money supply shifts the aggregate demand
curve to AD2. Since prices cannot rise, the short-run equilibrium is at point B, with output above
its full-employment level.
Figure 12.9
(b) When the price controls are removed, the price level will jump up, with the short-run aggregate
supply curve shifting to SRAS2. The new equilibrium is at point C, where there is full
employment.
6. (a) A new law that prohibits people from seeking employment before age eighteen is likely to reduce
the natural rate of unemployment because teenagers have a higher-than-average unemployment
rate. With no teenagers allowed in the labor force, the average unemployment rate would be lower.
(b) A service that makes looking for a job easier is able to match people and jobs more rapidly,
which should reduce the natural rate of unemployment.
(c) If unemployed workers can receive benefits longer, they’ll be in less of a rush to take a job, so
the job-matching process will take longer. As a result, the natural rate of unemployment will rise.
(d) A structural shift in the types of products people buy is likely to raise the natural rate of
unemployment, because it will take time for the economy to shift workers from some types
of occupations to others.
(e) A recession leads to a rise in cyclical unemployment, but doesn’t affect the natural rate of
unemployment.
2. A line through the origin with a slope of 2 is very close to the points on the line, confirming
Okun's law.
3. The fraction of unemployed workers who have been unemployed 15 weeks or more usually
rises in recessions and continues rising for a time after recessions end. The fraction of
unemployed workers who have been unemployed 15 weeks or more is positively related to the
unemployment rate. Thus, the costs to society of unemployment are higher in a recession than
in an expansion.