INFLATION AND

UNEMPLOYMENT
 Lecture Outline

• Inflation and the Price Level

• Demand-Pull Inflation
• Cost-Push Inflation
• Effects of Inflation
• The Phillips Curve
 Inflation and the Price Level

• Inflation is a process in which the price

level rises and money loses value.
• Inflation is fundamentally a monetary
phenomenon.
• The average level of prices is rising.
• Inflation is not high prices and inflation is
not a jump in prices
 Inflation and the Price Level
The figures
•• The figures
distinguishes
distinguishes
between aa
between
one time
one time
jump in
jump in
prices and
prices and
inflation.
inflation.
Part (b)
•• Part (b)
shows aa one
shows one
time jump
time jump in
in
the price
the price
level.
level.
 Inflation and the Price Level
• Part (a)
shows the
process of
inflation.
• The inflation
rate is the
percentage
change in the
price level
during a
given period.
 Causes of Inflation
• There are three main causes of Inflation.

• The Monetarist theory of inflation.

• Demand Pull Inflation (Keynesian theory).

• Cost Push Inflation.

 MONETARISTS
Economists who
•• Economists who traditionally
traditionally emphasize
emphasize thethe
important role
important role that
that the
the supply
supply ofof money
money plays
plays in
in
determining nominal
determining nominal income
income and
and inflation
inflation
Most famous
•• Most famous -- Milton
Milton Friedman,
Friedman, Nobel
Nobel laureate
laureate --
studied versions
studied versions ofof quantity
quantity equation
equation and
and role
role of
of
money in
money in economic
economic lifelife
Philip Cagan
•• Philip Cagan -- best
best known
known forfor work
work on
on
hyperinflations
hyperinflations
Monetarist economists
•• Monetarist economists did did pioneering
pioneering research
research onon
link between
link between money,
money, nominal
nominal income
income and
and inflation
inflation
 MONETARISTS
1. The monetarist explanation of inflation:
•• View inflation
View inflation exclusively
exclusively in
in terms
terms of
of increases
increases in
in
money supply
money supply

•• The foundation
The foundation is
is the
the quantity
quantity theory
theory of
of money
money byby
the classical
the classical school-
school- review
review the
the Fisher
Fisher equation
equation
-MV=PQ…(1)
-MV=PQ…(1)

•• Fisher concluded
Fisher concluded that
that given
given aa constant
constant VV and
and Q,
Q,
the price
the price level
level (P
(P )) will
will vary
vary directly
directly with
with the
the
quantity of
quantity of money
money (M)(M)
 Monetarists
The proportional
•• The proportional relationship
relationship between
between the
the
money supply
money supply and
and prices
prices can
can be
be shown
shown as
as
follows:
follows:
The elasticity
–– The elasticity of
of the
the price
price level
level with
with respect
respect to
to the
the
money supply
money supply (( Epm)
Epm) is:
is:
•• Epm= (dP/dM.
Epm= (dP/dM. M/P)….(2)
M/P)….(2)
•• Differentiate equation
Differentiate equation 11 totally
totally to
to obtain
obtain
•• MdV ++ VdM
MdV VdM == PdQ
PdQ ++ QdP…3
QdP…3
•• Letting dQ
Letting dQ and
and dV
dV == 00
•• VdM == QdP
VdM QdP and
and thus,
thus, dP/dM
dP/dM == V/Q….
V/Q…. 44
•• Substitute eq.
Substitute eq. 44 into
into eq.
eq. 22 to
to get:
get:
•• Epm == V/Q.M/P;
Epm V/Q.M/P; Since
Since V V == PQ/M
PQ/M ,, therefore
therefore
•• Epm == 1/Q.
Epm 1/Q. PQ/M
PQ/M .. M/P
M/P == 11
 Monetarists
• This establishes the proportionality
between the money supply (M) and
prices (P) when V and Q are constants
and only money (M) and prices (P) are
left free to vary
• Milton Friedman is often associated with
the modern quantity theory of money-he
argues that the main determinant of
aggregate spending is increases in the
money supply.
 Demand-Pull Inflation

• Demand-pull inflation is inflation

that results from an initial increase
in aggregate demand.
• A demand pull inflation can result
from any influence that increases
aggregate demand.
 Demand-Pull Inflation

• In a demand-pull inflation, initially

aggregate demand
–– aggregate demand increases
increases
real GDP
–– real GDP increases
increases above
above potential
potential
GDP and
GDP and the
the price
price level
level rises
rises
money wages
–– money wages rise
rise
the price
–– the price level
level rises
rises further
further and
and real
real
GDP decreases
GDP decreases toward
toward potential
potential GDP.
GDP.
 Demand-Pull Inflation
• A one-time increase in aggregate
demand raises the price level but
does not always start a demand-pull
inflation.
• For demand pull inflation to occur,
aggregate demand must persistently
increase.
• The money supply must persistently
grow at a rate that exceeds the
growth rate of potential GDP.
 Demand-Pull Inflation
• The figures
show a
demand pull
inflation.
• Initially,
aggregate
demand
increases.
 Demand-Pull Inflation
• Real GDP
increases
and the price
level rises.
• Now real
GDP
exceeds
potential
GDP.
 Demand-Pull Inflation
There is
•• There is an
an
inflationary
inflationary
gap.
gap.
The money
•• The money
wage rate
wage rate
begins to
begins to rise.
rise.
And the
•• And the SAS
SAS
curve shifts
curve shifts
leftward.
leftward.
 Demand-Pull Inflation
• Real GDP
decreases
toward
potential
GDP.
• The price
level rises
further.
 Demand-Pull Inflation
• This process
repeats in an
unending
price-wage
spiral.
 Cost-Push Inflation
• Cost-push inflation is an inflation
that results from an initial
increase in costs.
• The two main sources of cost-
push inflation are:
an increase
–– an increase in
in the
the money
money wage
wage rate
rate
an increase
–– an increase in
in the
the money
money prices
prices of
of
raw materials
raw materials
 Cost Push inflation
•• Other sources
Other sources of of cost
cost push
push inflation
inflation emphasizes
emphasizes thethe institutional
institutional
framework within
framework within which
which prices
prices and
and wages
wages are
are determined.
determined.

Trade unions
–– Trade unions agitate
agitate for
for higher
higher wages
wages by
by putting
putting pressures
pressures on on their
their
employers especially
employers especially governments
governments through
through the
the threat
threat of
of strikes.
strikes.

Rivalries may
–– Rivalries may also
also exist
exist between
between different
different unions
unions to
to secure
secure better
better pay
pay
for their
for their workers-this
workers-this may
may lead
lead to
to competitive
competitive bidding
bidding for
for better
better pay.
pay.

The combination
–– The combination of of all
all successful
successful demands
demands may may be
be greater
greater than
than the
the
increase in
increase in production
production that that follows
follows from
from the
the increase
increase in
in wages.
wages.
–– This
This may
may lead
lead to
to increase
increase in prices..
in prices
 Cost Push inflation
Alternatively, the
•• Alternatively, the rise
rise in
in wages
wages is
is viewed
viewed as
as an
an increase
increase in
in the
the
costs of
costs of production
production by by the
the producers.
producers.

This is
–– This is passed
passed on
on to
to the
the consumers
consumers in
in higher
higher prices
prices of
of goods
goods
and services.
and services.

This version
•• This version of
of cost
cost push
push theory
theory is
is called
called wage
wage push
push inflation
inflation

Profit push
•• Profit push occurs
occurs when
when firms
firms (especially
(especially oligopolistic
oligopolistic and
and
monopolistic firms)
monopolistic firms) have
have aa profit
profit margin
margin which
which they
they aim
aim at.
at.

An increase
•• An increase in
in the
the profit
profit margin
margin oror mark
mark up
up to
to offset
offset cost
cost
increases could
increases could lead
lead to
to inflation.
inflation.
 Cost-Push Inflation
• In a cost-push inflation, initially
short-run aggregate
–– short-run aggregate supply
supply
decreases
decreases
real GDP
–– real GDP decreases
decreases below
below
potential GDP
potential GDP and
and the
the price
price level
level
rises
rises
the economy
–– the economy could
could become
become stuck
stuck
in this
in this stagflation
stagflation situation
situation for
for
some time.
some time.
 Cost-Push Inflation

A one-time
•• A one-time decrease
decrease in in aggregate
aggregate
supply raises
supply raises the
the price
price level
level but
but does
does
not always
not always start
start aa cost-push
cost-push inflation.
inflation.
For cost-push
•• For cost-push inflation
inflation to
to occur,
occur,
aggregate demand
aggregate demand mustmust increase
increase in
in
response to
response to the
the cost
cost push.
push.
 Cost-Push Inflation

• Just like the case of demand-

pull inflation, the money supply
must persistently grow at a rate
that exceeds the growth rate of
potential GDP if an inflation is to
become persistent.
 Cost-Push Inflation
• The
following
figures
show a
cost-push
inflation.
• Initially, a
factor price
rises.
 Cost-Push Inflation
• Short-run
aggregate
supply
decreases
and the
SAS curve
shifts
leftward
 Cost-Push Inflation
• Real GDP
decreases
and the
price level
rises in a
stagflation.
 Cost-Push Inflation
• With no
subsequet
change in
aggregate
demand,
the price
level
eventually
falls.
 Cost-Push Inflation
• There is no
inflation.
• For cost-
push
inflation to
take hold,
aggregate
demand
must
increase.
 Cost-Push Inflation
An increase
•• An increase
in the
in the money
money
supply
supply
increases
increases
aggregate
aggregate
demand and
demand and
the AD
the AD curve
curve
shifts
shifts
rightward.
rightward.
 Cost-Push Inflation
• Real GDP
increases
and the
price level
rises.
 Cost-Push Inflation
• This
process
repeats to
create an
unending
cost-price
inflation
spiral.
 HYPERINFLATION
• Very high inflation rates, over 50% per
month
• Inflation rates observed in the US in
the last 40 years are insignificant in
comparison to some experiences
around the world throughout history
 HIGH INFLATIONS IN THE 1980s

Country
Country Bolivia Argentina
Bolivia Argentina Nicaragua
Nicaragua
Year
Year 1985
1985 1989
1989 1988
1988
Yearly Inflation
Yearly Inflation 1,152,
1,152, 200
200 975,
975, 000
000 302, 200
302, 200 Rate
Rate (%)
(%)
Monthly Inflation
Monthly Inflation 118
118 95
95 115
115 Rate (%)
Rate (%)
Monthly Money
Monthly Money 91 91 93
93 66
66 Growth
Growth
Rate (%)
Rate (%)
Source: International
Source: International Financial
Financial Statistics
Statistics Yearbook,
Yearbook, 1992,
1992,
(Washington DC:
(Washington DC: International
International Monetary
Monetary Fund)
Fund)
 DURING HYPERINFLATIONS
Money no
•• Money no longer
longer works
works very
very well
well in
in facilitating
facilitating
exchange
exchange
Since prices
•• Since prices areare changing
changing so so fast
fast and
and unpredictably,
unpredictably,
there is
there is typically
typically massive
massive confusion
confusion about
about the
the true
true
value of
value of commodities
commodities
Different stores
•• Different stores may
may be be raising
raising prices
prices atat different
different rates
rates
The same
•• The same commodities
commodities may may sell
sell for
for radically
radically different
different
prices
prices
Everyone spends
•• Everyone spends all
all their
their time
time hunting
hunting forfor bargains
bargains and
and
finding the
finding the lowest
lowest prices
prices
Governments are
•• Governments are forced
forced to to put
put an
an end
end toto hyperinflation
hyperinflation
before itit destroys
before destroys their
their economies
economies
 THE CAUSE OF HYPERINFLATION
Excessive money growth
• If a government wants to spend a specified
amount of money, but is collecting less in
taxes, it must cover the difference in some
way:
the government
–– the government may may borrow
borrow the
the difference
difference from
from the
the
public and
public and issue
issue bonds,
bonds, for
for which
which itit must
must pay
pay back
back
what itit borrows
what borrows and
and interest
interest in
in the
the future
future
the government
–– the government may may print
print new
new money
money
governments could
–– governments could mix
mix borrowing
borrowing and and printing
printing money
money
to cover
to cover the
the deficit
deficit

government deficit
government deficit == new
new borrowing
borrowing ++ new
new money
money created
created
 HYPERINFLATION
• occurs in countries that have large deficits,
but cannot borrow and are forced to print
new money
• is only stopped by eliminating the deficit,
which is the basic cause:
increase taxes
–– increase taxes
cut spending
–– cut spending
• Once the deficit has been cut and the
government stops printing money, the
hyperinflation will end
 Effects of Inflation
• Regardless of whether its origin is
demand-pull or cost-push, inflation
imposes costs.
• The costs depend on whether the
inflation is anticipated or unanticipated.
 Effects of Inflation
• Regardless of whether its origin is
demand-pull or cost-push, inflation
imposes costs.
• The costs depend on whether the
inflation is anticipated or unanticipated.
 ANTICIPATED INFLATION
Fully Anticipated
Fully Anticipated Inflation
Inflation
Inflation at
•• Inflation at 4%
4% would
would mean
mean workers
workers would
would know
know that
that
nominal wage
nominal wage increases
increases of
of 4%
4% were
were not
not real
real wage
wage
increases, and
increases, and

Investors earning
•• Investors earning aa 7%7% rate
rate of
of interest
interest on
on bonds
bonds
would know
would know that
that their
their real
real return
return would
would be
be 3%
3% after
after
adjusting for
adjusting for inflation
inflation
 The costs of expected inflation:
1. shoeleather cost
1.
def: the
•• def: the costs
costs and
and inconveniences
inconveniences ofof
reducing money
reducing money balances
balances to
to avoid
avoid the
the
inflation tax.
inflation tax.
••    ii
  real
 real money
money balances
balances
•• Remember: In
Remember: In long
long run,
run, inflation
inflation doesn’t
doesn’t
affect real
affect real income
income or or real
real spending.
spending.
•• So, same
So, same monthly
monthly spending
spending but but lower
lower
average money
average money holdings
holdings means
means more
more
frequent trips
frequent trips to
to the
the bank
bank toto withdraw
withdraw
smaller amounts
smaller amounts of of cash.
cash.
slide 41
The costs of expected inflation:
2. menu costs
2.

def: The
•• def: The costs
costs of
of changing
changing prices.
prices.
Examples:
•• Examples:
print new
–– print new menus
menus
print &
–– print & mail
mail new
new catalogs
catalogs
The higher
•• The higher is
is inflation,
inflation, the
the more
more
frequently firms
frequently firms must
must change
change their
their
prices and
prices and incur
incur these
these costs.
costs.

slide 42
 The costs of expected inflation:
3. relative price distortions
3.
Firms facing
•• Firms facing menu
menu costs
costs change
change prices
prices
infrequently.
infrequently.
Example:
•• Example:
Suppose aa firm
Suppose firm issues
issues new
new catalog
catalog each
each
January. As
January. As the
the general
general price
price level
level rises
rises
throughout the
throughout the year,
year, the
the firm’s
firm’s relative
relative price
price
will fall.
will fall.
Different firms
•• Different firms change
change their
their prices
prices atat different
different
times, leading
times, leading toto relative
relative price
price distortions…
distortions…
…which cause
•• …which cause microeconomic
microeconomic inefficiencies
inefficiencies
in the
in the allocation
allocation of of resources.
resources.
slide 43
 The costs of expected inflation:
4. unfair tax treatment
4.
Some taxes
Some taxes are
are not
not adjusted
adjusted toto account
account for
for
inflation, such
inflation, such as
as the
the capital
capital gains
gains tax.
tax.
Example:
Example:
 Jan
Jan 1:
1: you
you bought
bought $10,000
$10,000 worth
worth of
of
Starbucks stock
Starbucks stock
 Dec
Dec 31:
31: you
you sold
sold the
the stock
stock for
for $11,000,
$11,000,
so your
so your nominal
nominal capital
capital gain
gain was
was $1000
$1000
(10%).
(10%).
Suppose  == 10%
 Suppose 10% during
during the
the year.
year.
Your real
Your real capital
capital gain
gain is
is $0.
$0.
 But
But the
the govt
govt requires
requires you
you toto pay
pay taxes
taxes on
on
your $1000
your $1000 nominal
nominal gain!!
gain!! slide 44
 The costs of expected inflation:
5. General inconvenience
5.
Inflation makes
•• Inflation makes it
it harder
harder to
to compare
compare
nominal values
nominal values from
from different
different time
time
periods.
periods.
This complicates
•• This complicates long-range
long-range financial
financial
planning.
planning.

slide 45
 Effects of Inflation
The costs
•• The costs of
of anticipated
anticipated inflation
inflation are:
are:
other transactions
–– other transactions costs
costs
decrease in
–– decrease in potential
potential GDP
GDP
decrease in
–– decrease in the
the long-term
long-term growth
growth rate.
rate.
These costs
•• These costs have
have been
been estimated
estimated toto be
be
very high,
very high, even
even for
for aa modest
modest inflation.
inflation.
The main
•• The main problem
problem isis that
that taxes
taxes on
on capital
capital
income aa seriously
income seriously distorted
distorted by
by inflation.
inflation.
 Effects of Inflation
• Unanticipated inflation can cause the
following problems:
redistribute income
–– redistribute income between
between firms
firms and
and
workers
workers

move real
–– move real GDP
GDP away
away from
from potential
potential GDP
GDP

redistribute wealth
–– redistribute wealth between
between borrowers
borrowers
and lenders.
and lenders.
 Effects of Inflation
Borrowers gain
–– Borrowers gain in
in an
an inflation
inflation since
since at
at the
the time
time
the loan
the loan is
is to
to be
be repaid
repaid the
the real
real value
value of
of the
the
money used
money used to
to repay
repay the
the loan
loan is
is less
less than
than the
the
real value
real value when
when the
the money
money waswas borrowed.
borrowed.

On the
–– On the other
other hand,
hand, lenders
lenders lose
lose because
because thethe
money paid
money paid back
back will
will buy
buy less
less goods
goods andand
services than
services than at at the
the time
time the
the money
money waswas lent
lent
out.(inflationary premium
out.(inflationary premium are are often
often tied
tied to
to the
the
lending rate
lending rate to
to avoid
avoid this.
this.

–– This may
This may result
result in
in too
too much
much or
or too
too little
little
savings and
savings and investment
investment
 Effects of Inflation
Because unanticipated
•• Because unanticipated inflation
inflation is
is costly,
costly,
people try
people try to
to anticipate
anticipate it.
it.
To make
•• To make the the best
best possible
possible forecast
forecast of of
inflation, people
inflation, people use use all
all the
the information
information
they can
they can about
about thethe source
source of of inflation
inflation and
and
likely trends
likely trends in in those
those sources.
sources.
Such aa forecast
•• Such forecast is is called
called aa rational
rational
expectation.
expectation.
An anticipated
•• An anticipated inflation
inflation avoids
avoids some
some of of the
the
costs of
costs of inflation.
inflation.
 COSTS OF INFLATION
Anticipated Unanticipated
Inflation Inflation
Institutions do
Institutions do Distortions
Distortions in
in the
the Unfair
Unfair redistributions
redistributions not
not
adjusttax system,
adjusttax system, Problems in
Problems in
financial markets
financial markets
Institutions
Institutions Cost of
Cost of changing
changing Institutional
Institutional adjust
adjust
prices,
prices, disintegration
disintegration Shoe-leather
Shoe-leather
costs
costs
 THE PHILLIPS CURVE - 1
• The Phillips Curve is a graph depicting a
relationship between the unemployment
rate and the inflation rate. The figure below
shows a typical SHORT-RUN Phillips Curve.
 THE PHILLIPS CURVE - 2
The implication
•• The implication of
of the
the negative
negative slope
slope is
is that
that the
the
unemployment rate
unemployment rate andand the
the inflation
inflation rate
rate are
are
inversely related
inversely related -- in
in other
other words,
words, there
there is
is aa trade-
trade-
off between
off between the
the two.
two.

At the
•• At the beginning
beginning of
of the
the course,
course, one
one things
things we
we said
said
was that
was that society
society faces
faces aa short-run
short-run trade-off
trade-off
between inflation
between inflation and
and unemployment.
unemployment. This
This trade-
trade-
off is
off is embodied
embodied inin the
the short-run
short-run Phillips
Phillips Curve.
Curve.
 THE PHILLIPS CURVE - 3
Since inflation
•• Since inflation and
and unemployment
unemployment areare BOTH
BOTH
things we
things we don't
don't like,
like, the
the relationship
relationship between
between the
the
AD-AS (short-run)
AD-AS (short-run) macroeconomic
macroeconomic model
model and
and the
the
Phillips Curve
Phillips Curve are
are important.
important.

Understanding the
•• Understanding the relationship
relationship between
between economic
economic
policy and
policy and the
the inflation-unemployment
inflation-unemployment trade-off
trade-off is
is
key to
key to your
your understanding
understanding ofof macroeconomics.
macroeconomics.
 SHIFTS IN AD & THE PHILLIPS
CURVE - 1
Q: What happens in the Phillips Curve
diagram when there is a shift in AD?

A: There is a movement along the short-run

Phillips Curve and a trade-off between
inflation and unemployment.
SHIFTS IN AD & THE PHILLIPS
CURVE - 2
 SHIFTS IN AD & THE PHILLIPS
CURVE - 3
•• In the
In the previous
previous slide,
slide, AD
AD increases
increases from
from AD1
AD1 to
to
AD2. As
AD2. As aa result,
result, the
the equilibrium
equilibrium inin the
the economy
economy
moves from
moves from point
point AA to
to point
point B.
B.
•• There are
There are two
two important
important things
things to
to notice
notice about
about
the new
the new equilibrium
equilibrium (relative
(relative to
to the
the old
old one):
one):
First, notice
–– First, notice that
that the
the price
price level
level in
in the
the economy
economy has has
increased (from
increased (from 102
102 to
to 106)
106) -- therefore,
therefore, the
the rate
rate of
of
inflation has
inflation has risen.
risen.
Second, the
–– Second, the level
level of
of output
output produced
produced in in the
the economy
economy
has risen
has risen (from
(from Y1Y1 to
to Y2).
Y2). When
When thethe level
level of
of output
output
increases, the
increases, the number
number of of people
people employed
employed alsoalso rises,
rises,
indicating that
indicating that the
the unemployment
unemployment rate rate MUST
MUST have
have
fallen.
fallen.
 SHIFTS IN AD & THE PHILLIPS
CURVE - 4
•• Relative to
Relative to point
point A A in
in the
the figure
figure on
on the
the right,
right,
point B
point B MUST
MUST be be aa point
point where
where there
there isis higher
higher
inflation and
inflation and lower
lower unemployment
unemployment -- but but this
this just
just
represents aa movement
represents movement ALONG ALONG the the short-run
short-run
Phillips Curve.
Phillips Curve. Also,
Also, if
if AD
AD were
were to
to shift
shift in
in the
the
opposite direction,
opposite direction, there
there would
would have
have been
been aa
movement along
movement along thethe Phillips
Phillips Curve
Curve in in the
the
opposite direction.
opposite direction.
 THE LONG-RUN PHILLIPS
CURVE - 1
The figure below depicts the long-run Phillips
Curve:
 THE LONG-RUN PHILLIPS
CURVE - 2
• Earlier in the course, we discussed the
natural rate of unemployment. This was
defined to be about 6% in the long-run,
and it was shown that the economy tends
to automatically return to this level on its
own.
• If this is true, then the long-run Phillips
Curve is quite easy to draw - it MUST be a
vertical line at 6% unemployment!
 THE LONG-RUN PHILLIPS
CURVE - 3
• If the long-run Phillips Curve is vertical at
6%, then policymakers must be able to
choose any inflation rate they desire along
this line.

Q: What is the cost of reducing inflation in

the long-run?

A: In the long-run, there is NO cost to

reducing inflation.
 THE LONG-RUN PHILLIPS
CURVE - 4
This is demonstrated in the figures below:
 THE LONG-RUN PHILLIPS
CURVE - 5
•• On the
On the left,
left, if
if the
the Fed
Fed reduces
reduces the
the growth
growth ofof the
the
money supply
money supply in in the
the long-run,
long-run, the
the AD
AD curve
curve will
will
shift to
shift to the
the left,
left, causing
causing the
the price
price level
level to
to fall
fall
from P0
from P0 to
to P1.
P1.

•• However, output
However, output isis NOT
NOT affected
affected by
by changes
changes inin
the money
the money supply
supply in in the
the long-run
long-run (because
(because ofof
monetary neutrality).
monetary neutrality). Since
Since output
output remains
remains at
at the
the
natural rate
natural rate of
of output,
output, unemployment
unemployment remains
remains at
at
the natural
the natural rate
rate of
of unemployment.
unemployment.
 THE LONG-RUN PHILLIPS
CURVE - 6
•• On the
On the right,
right, the
the reduction
reduction in
in the
the growth
growth of
of the
the
money supply
money supply has
has lowered
lowered the
the long-run
long-run rate
rate of
of
inflation and
inflation and has
has NOTNOT affected
affected the
the long-run
long-run
unemployment rate.
unemployment rate.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 1

• While there is not a trade-off between

inflation and unemployment in the long-
run, there IS a short-run trade-off.
• From the work of Milton Friedman and
Edmund Phelps, we know that
expectations of future inflation plays an
important role in the short-run trade-off.
• THE SHORT-RUN PHILLIPS CURVE &
EXPECTATIONS -
• The natural rate of unemployment is that rate of
unemployment that exists when workers and
employers correctly anticipate the rate of inflation
• In the long run, expected inflation adjusts to
changes in actual inflation
• Once people anticipate inflation, the only way to
get unemployment below the natural rate is for
actual inflation to be above the anticipated rate.
THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 2
The figure
The figure below
below demonstrates
demonstrates the
the relationship
relationship
between the
between the short-run
short-run Phillips
Phillips Curve
Curve andand
inflationary expectations:
inflationary expectations:
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 3
• Suppose the economy is initially at point
‘A’. Earlier we said that a shift in the AD
curve will cause a movement along the
short-run Phillips Curve.

• An increase in the money supply, an

increase in government spending or a tax
cut could all shift the AD curve to the right
- suppose one of these three occurs.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 4
•• The rightward
The rightward shift
shift inin AD
AD isis associated
associated withwith
rising output
rising output and
and aa rising
rising price
price level.
level.
•• The rising
The rising price
price level
level IS
IS an
an increase
increase inin the
the rate
rate of
of
inflation.
inflation.
•• Rising output
Rising output goesgoes alongalong withwith rising
rising
employment (and
employment (and falling
falling unemployment).
unemployment).
•• For these
For these reasons,
reasons, the
the rightward
rightward shift
shift in
in AD
AD will
will
cause aa movement
cause movement to to point
point ‘B’
‘B’ in
in this
this figure
figure
(higher inflation
(higher inflation and
and lower
lower unemployment
unemployment than than
point ‘A’).
point ‘A’).
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 5

• Now, according to Friedman and Phelps,

the higher ACTUAL inflation will eventually
cause EXPECTED inflation to rise as well.

• The increase in EXPECTED inflation shifts

the short-run Phillips Curve to the right (to
SR-PC2), and the economy ends up at
point ‘C’.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 6
•• We can
We can describe
describe SR-PC2
SR-PC2 as
as aa ‘short-run
‘short-run Phillips
Phillips
Curve with
Curve with high
high expected
expected inflation’,
inflation’, while
while the
the
original curve,
original curve, SR-PC1
SR-PC1 can
can bebe described
described as
as aa
‘short-run Phillips
‘short-run Phillips Curve
Curve with
with low
low expected
expected
inflation’.
inflation’.

•• The result
The result you
you should
should take
take from
from thethe previous
previous
figure is
figure is that
that government
government policies
policies attempting
attempting toto
EXPAND aggregate
EXPAND aggregate demand
demand areare likely
likely to
to cause
cause
permanently HIGHER
permanently HIGHER rates
rates of
of inflation,
inflation, without
without
affecting the
affecting the long-run
long-run unemployment
unemployment rate.rate.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 7
•• The relationship
The relationship between
between the
the short-run
short-run Phillips
Phillips
Curve and
Curve and inflationary
inflationary expectations
expectations described
described
by Friedman
by Friedman and and Phelps
Phelps isis stated
stated inin the
the
following formula:
following formula:
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 8
•• In the
In the previous
previous example,
example, when
when ACTUAL
ACTUAL inflation
inflation
exceed EXPECTED
exceed EXPECTED inflation
inflation (at
(at point
point ‘B’),
‘B’),
unemployment was
unemployment was LESS
LESS THAN
THAN the
the natural
natural rate.
rate.
In the
In the long-run,
long-run, actual
actual and
and expected
expected inflation
inflation will
will
be equal,
be equal, and
and unemployment
unemployment will
will equal
equal thethe
natural rate
natural rate (and
(and the
the economy
economy will
will be
be back
back onon
the long-run
the long-run Phillips
Phillips Curve).
Curve).
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 1
Q: What happens in the Phillips Curve
diagram when the AS curve shifts?

A: The short-run Phillips Curve shifts,

changing the attractiveness of the trade-
off between inflation and unemployment.
SUPPLY SHOCKS & THE
PHILLIPS CURVE - 2
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 3
• The figure on the left in the previous slide
depicts a typical supply shock in the
economy (like the OPEC shocks in the
1970s).

• As the AS curve shifts to the left, the

equilibrium in the marcoeconomy moves
from point A to point B.
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 4
•• As with
As with aa shift
shift in
in the
the AD
AD curve,
curve, there
there are
are two
two
things you
things you should
should watch
watch for
for when
when AS
AS shifts:
shifts:

First, notice
–– First, notice that
that the
the equilibrium
equilibrium price
price level
level rises
rises
(from P1
(from P1 to
to P2),
P2), indicating
indicating that
that the
the level
level of
of inflation
inflation in
in
the economy
the economy has has risen.
risen.

Second, notice
–– Second, notice that
that the
the level
level of
of output
output produced
produced has
has
FALLEN from
FALLEN from Y1
Y1 to
to Y2.
Y2. As
As output
output falls
falls the
the number
number of of
labourers required
labourers required to
to produce
produce this
this output
output also
also falls.
falls.
When these
When these workers
workers get
get laid
laid off,
off, the
the unemployment
unemployment
rate RISES.
rate RISES.
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 5
•• In the
In the figure
figure on
on the
the right,
right, point
point BB MUST
MUST be be aa
point with
point with aa higher
higher inflation
inflation rate
rate AND
AND aa higher
higher
unemployment rate.
unemployment rate.
•• Point B
Point B MUST
MUST bebe upup and
and to
to the
the right
right of
of point
point A.
A.
Because of
Because of this,
this, economists
economists say say that
that the
the short-
short-
run Phillips
run Phillips Curve
Curve must
must have
have shifted
shifted to
to the
the right.
right.
•• This means
This means that
that the
the trade-off
trade-off between
between inflation
inflation
and unemployment
and unemployment is is LESS
LESS attractive,
attractive, because
because
BOTH rates
BOTH rates have
have risen.
risen.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 1
•• The figure
The figure below
below illustrates
illustrates the
the cost
cost of
of reducing
reducing
inflation in
inflation in the
the short-run:
short-run:
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 2
•• To reduce
To reduce inflation,
inflation, thethe FedFed willwill run
run aa
contractionary monetary
contractionary monetary policy.
policy.
•• The reduction
The reduction inin the
the money
money supply
supply will
will shift
shift AD
AD
to the
to the left.
left.
•• Recall that
Recall that aa leftward
leftward shift
shift in
in ADAD will
will cause
cause
falling output
falling output and
and aa falling
falling price
price level.
level. The
The falling
falling
price level
price level means
means aa falling
falling rate
rate of
of inflation,
inflation, while
while
falling output
falling output means
means falling
falling employment
employment (which,
(which,
in turn,
in turn, means
means rising
rising unemployment).
unemployment).
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 3
•• The contractionary
The contractionary monetary
monetary policy
policy has has the
the
effect of
effect of moving
moving the the economy
economy from from point
point ‘A’
‘A’ to
to
point ‘B’
point ‘B’ in
in the
the figure.
figure. You
You should
should think
think of
of SR-
SR-
PC1 as
PC1 as the
the ‘short-run
‘short-run Phillips
Phillips Curve
Curve with
with HIGH
HIGH
inflationary expectations’.
inflationary expectations’.
•• At point
At point ‘B’
‘B’ inflation
inflation is
is lower
lower and,
and, inin the
the long-run,
long-run,
inflationary expectations
inflationary expectations willwill adjust
adjust downwards
downwards
to match
to match thethe lower
lower ACTUAL
ACTUAL inflation.
inflation. When
When this
this
occurs, the
occurs, the short-run
short-run Phillips
Phillips Curve
Curve willwill shift
shift
INWARD to
INWARD to SR-PC0
SR-PC0 (think
(think of of SR-PC0
SR-PC0 as as the
the
‘short-run Phillips
‘short-run Phillips Curve
Curve with
with lowlow inflationary
inflationary
expectations’.
expectations’.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 4
Q: In this example, what WAS the short-run
cost of reducing inflation?

A: Temporarily higher unemployment.

However, as stated before, there is NO
long-run cost to reducing inflation,
because the economy returned to the
natural rate of unemployment as
inflationary expectations adjusted.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 5
Q: How
Q: How big
big is
is the
the cost
cost of
of reducing
reducing inflation
inflation in
in
reality?
reality?

A: There
A: There are
are two
two schools
schools of
of thought:
thought:
The Sacrifice
–– The Sacrifice Ratio.
Ratio.
Rational Expectations.
–– Rational Expectations.
 THE SACRIFICE RATIO
•• The Sacrifice
The Sacrifice Ratio
Ratio is
is the
the number
number ofof percentage
percentage points
points of
of
annual output
annual output lost
lost in
in the
the process
process ofof reducing
reducing inflation
inflation by
by
11 percentage
percentage point.
point. AA typical
typical sacrifice
sacrifice ratio
ratio is
is 5,
5, meaning
meaning
that reducing
that reducing inflation
inflation byby 1%
1% will
will reduce
reduce the
the output
output of
of
the economy
the economy by by 5%.
5%.

•• When Paul
When Paul Volcker
Volcker waswas the
the Chairman
Chairman of of the
the Federal
Federal
Reserve, he
Reserve, he wanted
wanted to to reduce
reduce inflation
inflation from
from about
about 10%
10%
to about
to about 4%,
4%, meaning
meaning thatthat the
the output
output of
of the
the economy
economy
might drop
might drop byby as
as much
much as as 30%
30% (that's
(that's as
as large
large as
as the
the
drop during
drop during the
the Great
Great Depression
Depression fromfrom 1929-1933).
1929-1933). This
This
school of
school of thought
thought indicates
indicates that
that the
the short-run
short-run cost
cost of
of
reducing inflation
reducing inflation is
is rather
rather large.
large.
 RATIONAL EXPECTATIONS - 1
•• Rational Expectations
Rational Expectations isis aa theory
theory according
according to
to which
which
people optimally
people optimally use
use all
all the
the information
information they
they have
have when
when
forecasting the
forecasting the future.
future.

•• Drawing on
Drawing on the
the analysis
analysis ofof Friedman
Friedman andand Phelps,
Phelps, rational
rational
expectations (which
expectations (which is is attributed
attributed toto Lucas,
Lucas, Sargent
Sargent and and
Barro) claims
Barro) claims that
that the
the short-run
short-run cost
cost of
of reducing
reducing inflation
inflation
will be
will be related
related to to the
the speed
speed with
with which
which inflationary
inflationary
expectations adjust.
expectations adjust. Rational
Rational expectations
expectations implies
implies that
that
the sacrifice
the sacrifice ratio
ratio could
could be be much
much lower
lower than
than 55 ifif the
the
commitment to
commitment to lower
lower inflation
inflation by
by the
the Fed
Fed isis seen
seen as as
‘CREDIBLE’. In
‘CREDIBLE’. In other
other words,
words, ifif people
people in in the
the economy
economy
immediately believe
immediately believe that
that the
the Fed
Fed WILL
WILL reduce
reduce inflation,
inflation,
inflationary expectations
inflationary expectations could could adjust
adjust downwards
downwards
immediately, and
immediately, and the
the sacrifice
sacrifice ratio
ratio could
could bebe 0.
0.
 RATIONAL EXPECTATIONS - 2
•• When Paul
When Paul Volcker
Volcker implemented
implemented his
his disinflation
disinflation
policies in
policies in the
the early
early 1980s,
1980s, there
there was
was neither
neither aa
30% drop
30% drop in
in economic
economic output,
output, nor
nor aa 0%
0% drop
drop inin
economic output.
economic output.

•• The fact
The fact that
that the
the drop
drop was
was greater
greater than
than 0%0%
caused many
caused many economists
economists to to refute
refute the
the
conclusions of
conclusions of rational
rational expectations,
expectations, while
while the
the
much less
much less than
than 30%30% drop
drop inin output
output caused
caused
proponents of
proponents of rational
rational expectations
expectations toto claim
claim
success (stating
success (stating that
that people
people reacted
reacted to
to the
the Fed’s
Fed’s
policy, but
policy, but NOT
NOT immediately).
immediately).