Relating Inflation and Unemployment

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Lesson 16-1 Relating
Inflation and Unemployment
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The Phillips Curve   A Phillips curve suggests a
negative relationship between inflation and
unemployment.   The Phillips curve trade-off
between inflation and unemployment is implied
by Keynesian analysis.   The experience of the
1960s suggested that the Phillips curve did exist
in the United States.
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The Phillips Curve Goes Awry   In the 1970s, both
the unemployment rate and the inflation rate rose
and fell simultaneously.   The 1960s appear to be
atypical.   Empirical evidence shows no sign of a
meaningful Phillips Curve relationship over the
period 1961 to 1998.
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The Cycle of Inflation and Unemployment   The
Phillips phase is a period in which inflation
rises as unemployment falls.   The stagflation
phase is a period marked by high inflation and
increasing unemployment.   The recovery phase is
a period in which inflation and unemployment both
decline.   The inflation-unemployment cycle is
the pattern of a Phillips phase, stagflation
phase, and recovery phase observed in the
relationship between inflation and
unemployment.   The data show that the economy
went through three inflation-unemployment cycles
during the 1970s.
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Explaining the Inflation-Unemployment Cycle   The
Phillips Phase Increasing Aggregate
Demand   Start from a recessionary gap to which
authorities respond with expansionary monetary or
fiscal policy.   Aggregate demand increases,
pushing real GDP and the price level up along the
short-run aggregate supply curve and lowering
unemployment.   Impact lags in macroeconomic
policy lead to continuing increases in aggregate
demand in subsequent periods and the repetition
of the process above.  
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The rising employment and real GDP occur because
sticky prices and wages that in the face of
nominal price increases are reduced in value give
an incentive to expand employment.   Eventually
workers and firms will begin adjusting nominal
wages and other sticky prices to reflect the new
higher level of prices that emerges during the
Phillips phase.
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Changes in Expectations and the Stagflation
Phase   Workers and firms adjust their
expectations to a higher price level, resulting
in new agreements on wages with higher nominal
wages.   Higher wages cause a leftward shift of
the short-run aggregate supply curve.   This
decrease in the short-run aggregate supply curve
results in increases in both unemployment and
inflation.   The essential feature of the
stagflation phase is a change in expectations.
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The Recovery Phase   Government attempts to stop
the recession created in the stagflation
phase.   Expansionary macroeconomic policy shifts
the aggregate demand to create a new equilibrium
of aggregate demand and SRAS.   This results in
lower unemployment and higher prices, but the
price rise is less than before, so the inflation
rate is lower.   There are other determinants of
inflation and unemployment.  
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Changes in production costs shift the short-run
aggregate supply curve. Depending on when such
shifts occur, they can reinforce or reduce the
swings in inflation and unemployment.   Lags also
play a crucial role in the cycle.   Because of
the lags in expansionary policy policymakers may
respond a second time too quickly and create
overstimulation in subsequent periods.