Ch22 - Short Run Tradeoff Between Inflation and Unemployment

N.
GREGORY MANKIW NINTH EDITION
PRINCIPLES OF
MACRO
ECONOMICS
CHAPTER The Short-Run Trade-off
between Inflation and
Unemployment
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
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IN THIS CHAPTER
• How are inflation and unemployment related
in 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?
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
2
Inflation and Unemployment
• In the long run, inflation and
unemployment are unrelated:
– The inflation rate depends mainly on
growth in the money supply.
– Unemployment (the “natural rate”)
depends on the minimum wage, the
market power of unions, efficiency wages,
and the process of job search.
In the short run, society faces a trade-off
between inflation and unemployment.
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 3
Origins of the Phillips Curve
• Phillips curve, PC:
– Short-run trade-off between inflation and
unemployment
• 1958: A.W. Phillips
– Nominal wage growth was negatively
correlated with unemployment in the U.K.
• 1960: Paul Samuelson & Robert Solow
– Negative correlation between U.S. inflation &
unemployment
– Named it “the Phillips Curve.”
Deriving the Phillips Curve
Suppose P = 100 this year.
The following graphs show two possible
outcomes for next year:
Point A: Low aggregate demand,
small increase in P (i.e., low inflation),
low output, high unemployment.
Point B: High aggregate demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.
5
Deriving the Phillips Curve
Point A: Low aggregate demand, low inflation, high u-rate
P inflation
SRAS
B B
5%
105
A
103 3% A
AD2
PC
AD1
Y1 Y2 Y 4% 6% u-rate
Point B: High aggregate demand, high inflation, low u-rate
6
The Phillips Curve: A Policy Menu?
• Since fiscal and monetary policy affect
aggregate demand,
– The PC appears to offer policymakers a menu of
choices:
• Low unemployment with high inflation
• Low inflation with high unemployment
• Anything in between
• 1960s: U.S. data supported the PC
– Many believed the PC was stable and
reliable
Evidence for the Phillips Curve?
During the 1960s,

Inflation rate (% per year)
10
U.S. policymakers
8 opted for reducing
unemployment
6 at the expense of
4 1968 higher inflation
1966
1967
2 1962
1965
1961
1964 1963
0
0 2 4 6 8 10
Unemployment rate (%)
8
The Vertical Long-Run Phillips Curve
• 1968, Milton Friedman, Edmund Phelps:
– Argued that the tradeoff was temporary
– Based on the classical dichotomy and the
vertical LRAS curve
• Natural-rate hypothesis:
– The claim that unemployment eventually
returns to its normal or “natural” rate,
regardless of the inflation rate
The vertical long-run Phillips Curve
In the long run, faster money growth only causes faster
inflation.
P LRAS inflation
LRPC
P2 high
inflation
P1 AD2
low
AD1 inflation
Y u-rate
Natural rate Natural rate of
of output unemployment
10
The Meaning of “Natural”
• Natural rate of unemployment
– Unemployment rate toward which the
economy gravitates in the long run
– Is not necessarily the socially desirable
rate of unemployment
– Is not constant over time
• This unemployment is natural because it
is beyond the influence of monetary policy
Reconciling Theory and Evidence
• Evidence (from 1960s):
– PC slopes downward
• Theory (Friedman and Phelps):
– PC is vertical in the long run.
• Friedman and Phelps, bridge the gap
between theory and evidence
– Introduced a new variable, expected inflation: a
measure of how much people expect the price
level to change
The Phillips Curve Equation
u-rate = Natural – a Actual – Expected

u-rate inflation inflation
• Short run
– The Fed can reduce u-rate below the natural u-
rate by making inflation greater than expected.
• Long run
– Expectations catch up to reality, u-rate goes
back to natural u-rate whether inflation is high or
low.
How expected inflation shifts the PC
Initially, expected &
actual inflation = 3%, inflation
unemployment = LRPC
natural rate (6%).
Fed makes inflation B C
2% higher than expected, 5%
u-rate falls to 4%. 3% A
In the long run, expected PC2
inflation increases to 5%, PC1
PC shifts upward, u-rate
4% 6%
unemployment returns to its
natural rate.
14
Active Learning 1: A numerical example
Natural rate of unemployment = 5%
Expected inflation = 2%
In PC equation, a = 0.5
A. Plot the long-run Phillips curve.
B. Find the u-rate for each of these values of actual
inflation: 0%, 6%. Sketch the short-run PC.
C. Suppose expected inflation rises to 4%.
Repeat part B.
D. Instead, suppose the natural rate falls to 4%.
Draw the new long-run Phillips curve,
then repeat part B.
15
The breakdown of the Phillips Curve
Early 1970s: unemployment increased,
despite higher inflation.
10
8
Friedman & Phelps’
1973
6 explanation:
1969 1970 1971
4 1968 expectations were
1972
1966 catching
1967
2 1965
1962 up with reality.
1961
1964 1963
0
0 2 4 6 8 10
16
Supply Shocks
• Supply shock:
– An event that directly alters firms’ costs
and prices
– Shifting the AS and PC curves
– Example: large increase in oil prices
• 1974 and 1979, OPEC restricted the supply
of oil: higher oil prices
How an adverse supply shock shifts the PC
SRAS shifts left, prices rise, output & employment fall.
P inflation
SRAS2
SRAS1
B B
P2
P1 A A
PC2
AD PC1
Y2 Y1 Y u-rate
Inflation & u-rate both increase as PC shifts upward.

18
The 1970s oil price shocks
Oil price per barrel

The Fed chose to
1/1973 $ 3.56
accommodate the first shock
1/1974 10.11 in 1973 with faster money
1/1979 14.85 growth.
1/1980 32.50 Result:
1/1981 38.00 Higher expected inflation,
which further shifted PC.
1979:
Oil prices surged again,
worsening the Fed’s tradeoff.
19
Inflation rate (% per year) The 1970s oil price shocks
10 1981 1975
1974
1980
8 1979
1978
Supply shocks &
6 1977
rising expected
1973
1976 inflation worsened
4 1972 the PC tradeoff.
2
0
0 2 4 6 8 10
20
The Cost of Reducing Inflation
• Disinflation:
– A reduction in the inflation rate
• To reduce inflation,
– The Fed has to pursue contractionary
monetary policy, which reduces AD
– Short run: output falls and unemployment
rises.
– Long run: output & unemployment return
to their natural rates.
Disinflationary monetary policy
inflation
LRPC
Contractionary monetary
policy moves economy
A
from A to B.
Over time, B
expected inflation falls, C
PC shifts downward. PC1
PC2
In the long run,
point C: the natural rate u-rate
of unemployment, natural rate of
lower inflation. unemployment
22
Sacrifice Ratio
• Sacrifice ratio:
– Percentage points of annual output lost
per 1 percentage point reduction in inflation
– Typical estimate: 5 (to reduce inflation rate 1%,
must sacrifice 5% of a year’s output)
– Can spread cost over time: to reduce inflation by
6%, can either
• sacrifice 30% of GDP for one year
• sacrifice 10% of GDP for three years
Rational Expectations, Costless Disinflation?
• Rational expectations:
– Theory according to which people
optimally use all the information they have
• Including info about government policies,
when forecasting the future
– Early proponents: Robert Lucas, Thomas
Sargent, Robert Barro.
– Implied that disinflation could be much
less costly.
EXAMPLE 1: Rational expectations
Suppose the Fed convinces everyone it is
committed to reducing inflation.
– Then, expected inflation falls, the short-

run PC shifts downward.
– Result: disinflations can cause less
unemployment than the traditional
sacrifice ratio predicts.
25
The Volcker Disinflation
• Fed Chairman Paul Volcker
– Appointed in late 1979 under high inflation &
unemployment
– Changed Fed policy to disinflation
• 1981–1984: Fiscal policy was expansionary
– 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.
The Volcker disinflation
Disinflation turned out to be very costly
10 1981
1980
8 1979
6 1982
1984 u-rate
4
1983 near 10% in
1987 1985
2 1986
1982–83
0
0 2 4 6 8 10
27
The Greenspan Era
• 1986: Oil prices fell 50%.
• 1989–90: Unemployment fell, inflation rose.
– Fed raised interest rates, caused a mild
recession
• 1990s: Unemployment and inflation fell.
• 2001:
– Negative demand shocks created the first
recession in a decade.
– Policymakers responded with expansionary
monetary and fiscal policy.
The Greenspan era
Inflation and unemployment were
10 low during most of Alan
Greenspan’s years as Fed

8 Chairman.
6
1990
2005
4
2006 1987
2 2000 1992
1998 1996 1994

0 2002
0 2 4 6 8 10
29
Phillips Curve During the Financial Crisis
• The early 2000s
– Housing market boom turned to bust in 2006
– Household wealth fell,
– Millions of mortgage defaults and
foreclosures
– Heavy losses at financial institutions
• Result:
– Sharp drop in aggregate demand, steep
rise in unemployment
Phillips Curve during and after the financial crisis
10.0
2006-2009: The financial crisis caused AD to
plummet, sharply increasing unemployment and
8.0
reducing inflation.
2010-2015: A slow recovery reduced
unemployment; inflation between 1 and 2%
6.0
By 2018: reduced unemployment below 4%;
inflation 2.4%
4.0
2006
2018 2007 2012 2011

2.0 2008
2017 2013 2010
2016 2014
2015 2009
0.0
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0
31
Conclusion
• Theories in this chapter teach us that
inflation and unemployment are:
– Unrelated in the long run
– Negatively related in the short run
– Affected by expectations, which play an
important role in the economy’s
adjustment from the short-run to the long
run
THINK-PAIR-SHARE
A worldwide drought has reduced food
production. Inflation has increased;
unemployment has risen above the natural
rate. Americans are frustrated with their
government. Your roommate says, “This
economic mess has got to be somebody’s
fault—probably the president or Congress. A
year ago, both inflation and unemployment
were lower. We need to vote in some
policymakers that know how to get rid of this
inflation and unemployment.”
33
THINK-PAIR-SHARE
A. Whose fault is the stagflation that is present in the
economy?
B. Are the current inflation and unemployment
choices facing the economy better or worse than
before the supply shock? What has happened to
the short-run Phillips curve?
C. If policymakers increase aggregate demand in
response to the supply shock, in what direction
will the economy move along the new short-run
Phillips curve? What will happen to inflation and
unemployment?
34
THINK-PAIR-SHARE
D. If policymakers decrease aggregate demand in
response to the supply shock, in what direction
will the economy move along the new short-run
Phillips curve? What will happen to inflation and
unemployment?
E. Is there a policy that can immediately reduce both
inflation and unemployment? Explain.
35
CHAPTER IN A NUTSHELL
• The Phillips curve (PC): negative relationship
between inflation and unemployment.
• By expanding AD: choose a point on PC with
higher inflation and lower unemployment.
• By contracting AD: choose a point on PC with
lower inflation and higher unemployment.
• This trade-off holds only in the short run.
• In the long run, expected inflation adjusts to
changes in actual inflation, the short-run PC shifts:
the long-run PC is vertical at the natural rate of
unemployment.
36
• The short-run Phillips curve also shifts because of
shocks to aggregate supply.
• An adverse supply shock (increase in world oil
prices), gives policy makers a less favorable
trade-off between inflation and unemployment.
• After an adverse supply shock, policymakers
have to accept a higher rate of inflation for any
given rate of unemployment or a higher rate of
unemployment for any given rate of inflation.
37
• When the Fed contracts growth in the money
supply to reduce inflation, it moves the economy
along the short-run Phillips curve, resulting in
temporarily high unemployment. The cost of
disinflation depends on how quickly expectations of
inflation fall.
• Some economists argue that a credible
commitment to low inflation can reduce the cost of
disinflation by inducing a quick adjustment of
expectations.
38

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N.

GREGORY MANKIW NINTH EDITION

During the 1960s,

u-rate = Natural – a Actual – Expected

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

Oil price per barrel

– Then, expected inflation falls, the short-

Greenspan’s years as Fed

1998 1996 1994

2018 2007 2012 2011

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