Lecture 7

The Short-Run Inflation-Unemployment Tradeoff, and

the Sacrifice Ratio

Accelerating Inflation
The Sacrifice Ratio
"Hysteresis"
Disinflation and the "Sacrifice Ratio"
Anti-Recession Policy, Cyclical Unemployment, and Structural Unemployment

Accelerating Inflation

Consider the options that the Phillips curve gives to someone trying to nudge the
economy to full employment with monetary and fiscal policy. At any single moment,
expected inflation and supply shocks are outside of control. Yet changing aggregate
demand alters output, unemployment, and inflation. Expanding aggregate demand is
close to guaranteed to produce higher output, lower unemployment, and higher inflation
Contracting aggregate demand is all but guaranteed to raise unemployment and lower
inflation.

Almost every time Alan Greenspan appears in front of Congress, he says something like
that this short-run tradeoff is "ephemeral and unusable". Why? Because the past
generation's experience strongly suggests that any systematic attempt to run a high-
pressure economy--to have a little bit lower unemployment and a little bit higher
inflation--is doomed to failure, because expectations of inflation will adjust upward. And
when they do you have a less favorable short-run tradeoff.

Thus in the long run, we are back where we were at the start of the course: chapter 3.
Output (and employment) are determined by "fundamentals": productivity and factor
supplies, if we are in a situation in which all expectations are satisfied.

How long is the long run? Probably more than five years.

The Sacrifice Ratio

In the late 1970s the M’sia economy had an "expected" and an actual inflation rate
somewhere near 8 percent per year (pushed up, temporarily, at the end of the end of the
1970s by supply shocks). Suppose--for the sake of argument--that that unemployment
was at its "natural rate", that gov sought to reduce inflation and expected inflation from
around 8 percent per year to around 3 percent, and that she had asked you to tell him
what was going to happen as she pursued this policy.

How do we think about this?

We have the result of our IS-LM apparatus:

(1) Y = Y(r)

If we think of the BNM as controlling interest rates. We have our short-run Phillips
curve:

(2) p = E(p) + (1/a)(Y-Y*)

But this is not enough; we need to know how expectations of inflation adjust over time.

One possibility is that people are pretty sophisticated in forming expectations of inflation.
They take a look at the economy as a whole--including a look at the monetary and fiscal
policies in effect--try to estimate how those policies are going to affect the economy, and
so form their expectations of inflation.

This possibility would suggest that the location of the short-term Phillips curve is easy to
shift--for good or for ill--that if a central bank or a government tries to expand
employment and keep it above "natural rates" the Phillips curve will shift upward rapidly;
conversely, the mere announcement of a change in policy could shift the short-run
Phillips curve: all you have to do is say "we are going to be tough on inflation; and you
find the Phillips curve shifting).

There is something to this:

 What Alan Greenspan did to the bond market on Tuesday
 In Mexico the inflation rate has gone from 1/2% per month to 2-3% per month
over the past year and a bit

But there is another approach--one that says that this "rational expectations" vision is
hopelessly naive:
People don't trust announcements of policies
People don't trust economic models
Hence, "show me"
This approach implies that reducing inflation will be much more painful; the only way to
push inflation down is to produce enough unemployment that you can show that inflation
has fallen.

How to influence expected inflation?

  Jawboning
 Incomes policies/price controls
 Show me (deep recessions)

Clearly the first two are to be preferred, if they work...

Clearly people are likely to be suspicious of the first two; naivete of the first; perversity
of the second (people react to incomes policies by raising their expectations of what will
happen after the end of the program): Nixon: these policies will do a lot less damage as
implemented by us, who don't believe in them, than if implemented by true believers.
Importance of "credibility": Thatcher and the MTFS; Reagan and the hope for painless
disinflation in the early 1980s.

So: once again: Suppose--for the sake of argument--that when Paul Volcker was named
to the Federal Resrve, that unemployment was at its "natural rate", that Volcker sought to
reduce inflation and expected inflation from around 8 percent per year to around 3
percent, and that he had asked you to tell him what was going to happen as he pursued
this policy.

Suppose that expected inflation equals last year's inflation:

(3) pt = pt-1 + (1/a)(Yt - Y*t)

and suppose that you want to accomplish the reduction in inflation over a period of five
years. Then:

(4) p5 = p4 + (1/a)(Y5 - Y*5)

(5) p5 = p3 + (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4)

Keep substituting in; and eventually we have:

(6) p5 - p0 = (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4) + (1/a)(Y3 - Y*3) + (1/a)(Y2 - Y*2) + (1/a)
(Y1 - Y*1)

or

Lost Production (relative to potential output Y*) = a(p5 - p0)

Where a is the inverse slope of the Phillips curve.

Use Okun's Law to express this in terms of unemployment...

Between 1981 and 1985, 9.5 percentage point-years of cyclical unemployment; inflation
down by five percentage points. "Sacrifice ratio" of 1.9 for unemployment (or 3.8 for
output). Reducing inflation thus very expensive....
Tempted to leave inflation bouncing around in the 5-10 percent range. But (a) voters
hated inflation; (b) fear that permanent moderate inflation is a contradiction in terms...

"Hysteresis"

An extremely ugly word. Comes from study of magnetism. Attempt by Larry Summers
and Olivier Blanchard to create an intellectual movement to study peculiar problems of
European unemployment.

Brief history of European unemployment; unemployment rises a lot in recessions; it does

not fall much in booms

Natural rate hypothesis...

But recessions can shift the natural rate of unemployment as well; transformation of
cyclical into structural unemployment:
 atrophy of human capital
 labor force attachment
 insiders/outsiders
 endogenous policies

"Hysteresis" raises the sacrifice ratio: makes it infinite, in fact; most of the attraction of
disinflation is that you incur several bad years for something--lower inflation--of
permanent benefit. But in Europe over the past generation this has not been true.

The Macroeconomic Policy Debate

Mankiw, chapter 12.

Lecture 14 Equations

(1) Y = Y(r)
(2) p = E(p) + (1/a)(Y-Y*)
(3) pt = pt-1 + (1/a)(Yt - Y*t)
(4) p5 = p4 + (1/a)(Y5 - Y*5)
(5) p5 = p3 + (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4)
(6) p5 - p0 = (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4) + (1/a)(Y3 - Y*3) + (1/a)(Y2 - Y*2) + (1/a)
(Y1 - Y*1)

Lost Production (relative to potential output Y*) = a(p5 - p0)

 Aggregate Supply
Problem Set #5
Economics 100b; Spring 1996; Brad DeLong

1. Briefly summarize (one sentence on each) three reasons why businesses in the
aggregate react to increases in total demand by increasing their prices and increasing the
quantities they produce and sell (as opposed to increasing prices alone).
2. What is the Phillips curve? What is the difference between the original Phillips curve
and the accelerationist Phillips curve?

3. What is the difference between the short run and the long run Phillips curve?

4. When the economy experiences a positive "supply shock", does:

 inflation accelerate and unemployment rise
 inflation decelerate and unemployment rise
 inflation accelerate and unemployment fall
 inflation decelerate and unemployment fall?

5. When the economy experiences a positive "demand shock", does:

 inflation accelerate and unemployment rise

 inflation decelerate and unemployment rise
 inflation accelerate and unemployment fall
 inflation decelerate and unemployment fall?

6. Does the short-run inflation-unemployment Phillips curve for the U.S. today lie:

 above and to the right of the curve for the 1970s

 below and to the right of the curve for the 1970s
 above and to the left of the curve for the 1970s
 below and to the left of the curve for the 1970s?

7. What is the principal determinant of the location of the short run Phillips curve?

8. What is the principal determinant of the slope of the short run Phillips curve?