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CHAPTER
35 In this chapter,
look for the answers to these questions:
The Short-Run Trade-off Between ▪ How are inflation and unemployment related in the
Inflation and Unemployment short run? In the long run?
▪ What factors alter this relationship?
Economics
PRINCIPLES OF
▪ What is the short-run cost of reducing inflation?
N. Gregory Mankiw ▪ 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

▪ Suppose P = 100 this year. A. Low agg demand, low inflation, high u-rate

▪ The following graphs show two possible P inflation

outcomes for next year:
SRAS
A. Agg demand low, B
B 5%
small increase in P (i.e., low inflation), 105
low output, high unemployment. A
103 3% A
AD2
B. Agg demand high,
PC
big increase in P (i.e., high inflation), AD1
high output, low unemployment.
Y1 Y2 Y 4% 6% u-rate

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

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The Phillips Curve: A Policy Menu? Evidence for the Phillips Curve?
▪ Since fiscal and mon policy affect agg demand, Inflation rate
the PC appeared to offer policymakers a menu (% per year) During the 1960s,
of choices: U.S. policymakers
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▪ low unemployment with high inflation opted for reducing
unemployment
▪ low inflation with high unemployment 8
at the expense of
▪ anything in between 6 higher inflation
▪ 1960s: U.S. data supported the Phillips curve. 4 68
Many believed the PC was stable and reliable. 67
66
2 62
65
1961
64 63
0
0 2 4 6 8 10 Unemployment
rate (%)
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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. inflation
P
LRAS LRPC
▪ Natural-rate hypothesis: the claim that
unemployment eventually returns to its normal or high
P2
“natural” rate, regardless of the inflation rate infla-
tion
▪ Based on the classical dichotomy and the
vertical LRAS curve P1 AD2 low
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

▪ Evidence (from ’60s): Unemp.
Natural
PC slopes downward. = rate of – a Actual – Expected
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:
expected inflation – a measure of how much Long run
people expect the price level to change. Expectations catch up to reality,
u-rate goes back to natural u-rate whether inflation
is high or low.

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How Expected Inflation Shifts the PC ACTIVE LEARNING 1

A numerical example
Initially, expected &
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 A. Plot the long-run Phillips curve.
2% higher than expected, B C
5% B. Find the u-rate for each of these values of actual
u-rate falls to 4%.
A inflation: 0%, 6%. Sketch the short-run PC.
In the long run, 3%
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.
then repeat part B.
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ACTIVE LEARNING 1 The Breakdown of the Phillips Curve

Answers LRPCD
PCB LRPCA Inflation rate
7 (% per year) Early 1970s:
An increase
in expected 6 unemployment increased,
10
inflation Friedman &
despite higher inflation.
5 Phelps’
inflation rate

shifts PC to 8
the right. 4 explanation:
PCD 6 73 expectations
3 69 71
70 were catching
A fall in the PCC 4 68
2
66
72 up with reality.
natural rate 67
62
1 2
shifts both 65
1961
64 63
curves 0 0
to the left. 0 1 2 3 4 5 6 7 8 0 2 4 6 8 10 Unemployment
unemployment rate rate (%)
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Another PC Shifter: Supply Shocks How an Adverse Supply Shock Shifts the PC
▪ Supply shock: SRAS shifts left, prices rise, output & employment fall.
an event that directly alters firms’ costs and P inflation
prices, shifting the AS and PC curves SRAS2
▪ Example: large increase in oil prices SRAS1
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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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 10 81 75
1/1974 10.11 rising
with faster money growth. 74
1/1979 14.85 80 expected
8 79
Result: 78 inflation
1/1980 32.50
Higher expected inflation, 6 77 worsened
1/1981 38.00 which further shifted PC. 73
76 the PC
4 1972 tradeoff.
1979:
Oil prices surged again, 2
worsening the Fed’s tradeoff.
0
0 2 4 6 8 10 Unemployment
rate (%)
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The Cost of Reducing Inflation Disinflationary Monetary Policy

▪ Disinflation: a reduction in the inflation rate Contractionary monetary
policy moves economy
▪ To reduce inflation, from A to B.
inflation
LRPC
Fed must slow the rate of money growth,
Over time,
which reduces agg demand. expected inflation falls, A
▪ Short run: PC shifts downward.
B
Output falls and unemployment rises. In the long run, C
point C:
▪ Long run: the natural rate
PC1
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.
▪ Sacrifice ratio:
percentage points of annual output lost
per 1 percentage point reduction in inflation
▪ Typical estimate of the sacrifice ratio: 5
▪ To reduce inflation rate 1%,
must sacrifice 5% of a year’s output.
▪ Can spread cost over time, e.g.
To reduce inflation by 6%, can either
▪ sacrifice 30% of GDP for one year
▪ sacrifice 10% of GDP for three years
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▪ Rational expectations: a theory according to
which people optimally use all the information
they have, including info about govt policies,
when forecasting the future
▪ Early proponents:
Robert Lucas, Thomas Sargent, Robert Barro
▪ Implied that disinflation could be much less
costly…
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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 &
▪ Then, expected inflation falls, unemployment
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:
10 81 u-rate Unemployment fell, inflation rose.
80
near 10% Fed raised interest rates, caused a
8 1979
in 1982-83 mild recession.
6 82
▪ 1990s: Alan Greenspan
84 Unemployment and inflation fell. Chair of FOMC,
4 Aug 1987 – Jan 2006
87 85
83
▪ 2001: Negative demand shocks
2 86 created the first recession in a decade.
Policymakers responded with expansionary monetary
0
0 2 4 6 8 10 Unemployment and fiscal policy.
rate (%)
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The Greenspan Era Ben Bernanke’s challenges

Inflation rate
▪ Aggregate demand shocks:
(% per year) Inflation and unemployment ▪ Subprime mortgage crisis, falling housing prices,
were low during most of widespread foreclosures, financial sector troubles.
10
Alan Greenspan’s years
▪ Aggregate supply shocks:
8 as Fed Chairman.
▪ Rising prices of food/agricultural commodities, e.g.,
6 Corn per bushel: $2.10 in 2005-06, $5.76 in 5/2008
05
90 ▪ Rising oil prices
4
06 1987 Oil per barrel: $35 in 2/2004, $134 in 6/2008
2 2000 92
▪ From 6/2007 to 6/2008,
96 02 94
0
98
▪ unemployment rose from 4.6% to 5.5%
0 2 4 6 8 10 Unemployment ▪ CPI inflation rose from 2.6% to 4.9%
rate (%)
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CONCLUSION CHAPTER SUMMARY

▪ The theories in this chapter come from some of
the greatest economists of the 20th century.
▪ They 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.
▪ The Phillips curve describes the short-run tradeoff
between inflation and unemployment.
▪ In the long run, there is no tradeoff:
inflation is determined by money growth,
while unemployment equals its natural rate.
▪ Supply shocks and changes in expected inflation
shift the short-run Phillips curve, making the
tradeoff more or less favorable.

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CHAPTER SUMMARY

▪ The Fed can reduce inflation by contracting the

money supply, which moves the economy along its
short-run Phillips curve and raises unemployment.
In the long run, though, expectations adjust and
unemployment returns to its natural rate.
▪ Some economists argue that a credible
commitment to reducing inflation can lower the
costs of disinflation by inducing a rapid adjustment
of expectations.

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