The ShortRun Tradeoff Between Inflation and Unemployment

1
Chapter 21

• The Short-Run Tradeoff Between Inflation and
  Unemployment

2
Okuns Law

• u 0.5( 3 - g)
• where g GDP growth rate
• If g 3, u 0
• If g 5.
• u -1
• If g 1
• u 1

Thats the only formula today
3
Suppose Government Pushes Economy Beyond Its
Potential

• What is short-in impact on output, price level
  and unemployment?
• What is the long-run impact on these variables?

4
Suppose Economy Overheats

• Step 1 AD Rises - - P real GDP rise
• Step 2 AS Falls -- Inflationary Expectations
  Wages rise
• Step 3 Economy returns to natural rate of output

5
The Aggregate Demand and Aggregate Supply Model
Price Level
Aggregate Supply
A
PN
Aggregate Demand
QN
Quantity of Output
6
The Aggregate Demand and Aggregate Supply Model
AD Rises
Price Level
Aggregate Supply
B
PN
A
Aggregate Demand
QN
Quantity of Output
7
The Aggregate Demand and Aggregate Supply Model
AS Falls
Price Level
Aggregate Supply
C
B
A
PN
Aggregate Demand
QN
Quantity of Output
8
The Aggregate Demand and Aggregate Supply Model
AS Falls
Price Level
Aggregate Supply
C
B
PN
A
Aggregate Demand
QN
Quantity of Output
9
The Aggregate Demand and Aggregate Supply Model
AS Falls
Price Level
Aggregate Supply
C
B
PN
A
Aggregate Demand
LRAS
QN
Quantity of Output
10
The Long-Run Aggregate Supply Curve
Price Level
Aggregate Supply
The Long-Run Aggregate Supply Curve
Aggregate Demand
Quantity of Output
11
Inflation and Unemployment

• The Natural Rate of Unemployment
• depends on various features of the labor market,
  (e.g. minimum-wage laws, the market power of
  unions, the role of efficiency wages, and
  effectiveness of job search.)
• The Inflation Rate
• depends primarily on growth in the quantity of
  money, controlled by the Fed.

12
Inflation and Unemployment

• Macroeconomics focuses on - output, prices, and
  unemployment.
• AD shifts right lowers u rate increases
  inflation
• AD shifts left raises u rate lowers inflation

13
The Phillips Curve

• Illustrates shortrun tradeoff between inflation
  rate u rate
• Phillips Curve results from AD shifting along SR
  AS.

14
The Phillips Curve

• Illustrates the tradeoff between inflation and
  unemployment -- a short-run relationship.

15
Phillips Curve (Figure 21-2)
Inflation Rate
B
6
A
2
Unemployment Rate
0
4
7
16
Chapter 21 Outline

• Phillips Curve and AD AS framework How they
  interrelate
• The Costs of Reducing Inflation How quickly do
  peoples expectations change?

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The Phillips Curve, AD AS

• The greater AD, the greater output and the higher
  price level.
• A higher level of output results in lower
  unemployment.
• Monetary and fiscal policy can shift the AD
  curve, thus moving the economy along Phillips
  curve.

20
The Tradeoff Between Inflation and Unemployment

• Policymakers face a tradeoff between inflation
  and unemployment, and the Phillips Curve
  illustrates that tradeoff.
• Okuns law tells us that greater output means a
  lower rate of unemployment but at a higher
  overall price level.

21
The Tradeoff Between Inflation and Unemployment

• Policymakers face tradeoff between inflation and
  unemployment, and Phillips Curve illustrates
  that tradeoff

22
Shifts in the Phillips Curve

• Phillips curve once thought of as menu of
  possible economic outcomes.
• Phillips Curve can shift due to
• Expectations
• Supply Shocks

23
Shifts in the Phillips Curve

• The stable Phillips Curve broke down in the 1970s
  and 1980s. Both inflation unenployment rose
• Phillips Curve tradeoff short-run
• Long-Run Phillips Curve vertical at natural rate

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The Phillips Curve

• A Menu of Short Run Choices Between Inflation
  rate and Unemployment Rate
• But no long-run tradeoff
• How could these be reconciled?

27
The Phillips Curve

• Aggregate Demand / Aggregate Supply framework
  provides some insight...

28
Graphical Approach to Phillips Curve

• Step A Economy At Natural Rate and Low
  Inflation Expected

29
Graphical Approach to Phillips Curve

• Step A Economy At Natural Rate and Low
  Inflation Expected
• Step B AD rises, increasing inflation, output
  and lowering unemployment

30
Graphical Approach to Phillips Curve

• Step A Economy At Natural Rate and Low
  Inflation Expected
• Step B AD rises, increasing inflation, output
  and lowering unemployment
• Step C Inflationary expectations rise, and
  workers receive a higher wage rate

31
Graphical Approach to Phillips Curve

• Step A Economy At Natural Rate and Low
  Inflation Expected
• Step B AD rises, increasing inflation, output
  and lowering unemployment
• Step C Inflationary expectations rise, and
  workers receive a higher wage rate

32
Graphical Approach to Phillips Curve

• Step A
• Economy producing full employment level of
  output
• unemployment at natural rate( 5-6)
• expected inflation actual inflation

33
The Aggregate Demand and Aggregate Supply Model
Price Level
Aggregate Supply (2)
PN
A
Aggregate Demand
QN
Quantity of Output
34
Phillips Curve (Figure 21-2)
Inflation Rate
Phillips Curve (2)
6
2
A
Unemployment Rate
0
3
6
35
Graphical Approach to Phillips Curve

• Step B
• The Fed expands money supply
• AD rises
• inflation and output rise
• unemployment falls

36
The Aggregate Demand and Aggregate Supply Model
AD Rises
Price Level
Aggregate Supply (2)
B
PN
A
Aggregate Demand
QN
Quantity of Output
37
Phillips Curve (Figure 21-2)
Inflation Rate
Phillips Curve (2)
6
B
2
A
Unemployment Rate
0
3
6
38
Graphical Approach to Phillips Curve

• Step C
• Inflationary Expectations rise
• Workers wages rise
• AS shifts left
• Output returns to natural rate
• Price level rises

39
The Aggregate Demand and Aggregate Supply Model
AS Falls
Price Level
C
Aggregate Supply (2)
B
Aggregate Supply (6)
PN
A
Aggregate Demand
QN
Quantity of Output
40
Graphical Approach to Phillips Curve

• Note Back at Point C
• Expected Inflation Actual Inflation
• Output back to natural rate
• Points A and C on economys LRAS
• (long-run aggregate supply curve)

41
The Aggregate Demand and Aggregate Supply Model
AS Falls
Price Level
C
Aggregate Supply (2)
B
Aggregate Supply (6)
PN
A
Aggregate Demand
QN
Quantity of Output
42
Graphical Approach to Phillips Curve

• Step C
• When inflationary expectations rise
• Workers wages rise
• Inflation rises
• Output returns to natural rate
• unemployment rate returns to natural rate

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Phillips Curve (Figure 21-2)
Inflation Rate
Phillips Curve (2)
C
6
B
2
A
Unemployment Rate
0
3
6
44
Graphical Approach to Phillips Curve

• Points A and C on economys Long-Run Phillips
  Curve
• In long-run NO tradeoff between inflation and
  unemployment rates

45
Phillips Curve (Figure 21-2)
Inflation Rate
LRPC
Phillips Curve (2)
C
6
B
A
2
Unemployment Rate
0
3
6
46
Graphical Approach to Phillips Curve

• Passing through C is a short-run Phillips Curve
• expected inflation rate higher on new (purple)
  Phillips Curve

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Phillips Curve (Figure 21-2)
LRPC
Inflation Rate
Phillips Curve (2)
C
6
B
Phillips Curve (6)
A
2
Unemployment Rate
0
3
6
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Thats It Folks Thats the Show!
Outda time!
Good Luck on Final Everyone!
Dont Forget Reviews!
49
Quick Quiz!

• Draw the Phillips Curve.
• Use the model of aggregate supply and aggregate
  demand to show how policy can move the economy
  from a point on this curve with high inflation to
  a point with low inflation.

50
The Role of Expectations

• In the long-run, expected inflation adjusts to
  changes in actual inflation, and the short-run
  Phillips Curve shifts.
• Once people anticipate inflation, the only way to
  get unemployment below the natural rate is for
  actual inflation to be above the anticipated
  rate.
• As a result, the long-run Phillips Curve is
  vertical at the natural rate of unemployment.

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The Role of Expectations

• In the long-run, with a vertical Phillips Curve
  at the natural rate of unemployment, the actual
  rate of inflation and unemployment will depend
  upon aggregate supply factors and the fiscal and
  monetary policies pursued by the government.
• Figures 21-4 21-5

52
The Role of Expectations

• The view that unemployment eventually returns to
  its natural rate, regardless of the rate of
  inflation is called the natural-rate hypothesis.
• Figures 21-6 21-7 illustrate the historical
  observations that support the natural-rate
  hypothesis.

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Quick Quiz!

• Draw the short-run Phillips Curve and the
  long-run Phillips Curve.
• Explain why they are different.

54
Shifts in the Phillips Curve The Role of
Supply Shocks

• The short-run Phillips Curve also shifts because
  of shocks to aggregate supply.
• An adverse supply shock, such as an increase in
  world oil prices, gives policymakers a less
  favorable tradeoff between inflation and
  unemployment.
• Example 1974 OPEC actions

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The Role of Supply Shocks

• Major changes in aggregate supply can worsen
  the short-run tradeoff between unemployment and
  inflation.

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The Role of Supply Shocks

• Example OPEC in the 1970s (1) cut
  output and (2) raised prices. The tradeoff in
  this situation resulted in two choices (Figure
  21-8)
• Fight the unemployment battle with monetary
  expansion (and accelerate inflation).
• Stand firm against inflation (but endure even
  higher unemployment).

57
Quick Quiz!

• Give an example of a favorable shock to aggregate
  supply.
• Use the model of aggregate supply and aggregate
  demand to explain the effects of such a shock.
• How does it affect the Phillips Curve?

58
The Cost of Reducing Inflation

• Which Theory is Correct Regarding the Short-term
  Costs of Reducing Inflation?

59
Theory Number One

• The Inflation Rate can only be reduced by
  suffering through a period of high unemployment

60
The Cost of Reducing Inflation

• To reduce inflation, the Fed has to pursue
  contractionary monetary policy (e.g. raising
  interest rates, etc.)
• When the Fed slows the rate of money growth
• It contracts the aggregate demand, which
• reduces the quantity of goods and services
  that firms produce, which
• leads to a fall in employment.

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AD and AS Model High Expected Inflation
Price Level
Aggregate Supply
C
PN
Aggregate Demand
QN
Quantity of Output
62
AD and AS Model High Expected Inflation
Price Level
Aggregate Supply
C
PN
Aggregate Demand
QN
Quantity of Output
63
Phillips Curve (Figure 21-2)
Inflation Rate
C
6
2
Unemployment Rate
0
3
6
64
The Cost of Reducing Inflation

• Given the actions of the Fed in combating
  inflation, the economy moves along (downward) the
  short-run Phillips Curve, resulting in lower
  inflation but higher unemployment.
• If an economy is to reduce inflation it must
  endure a period of high unemployment and low
  output.

65
The Cost of Reducing Inflation

• The sacrifice ratio is the number of percentage
  points of annual output that is lost in the
  process of reducing inflation by one percentage
  point.
• A typical estimate of the sacrifice ratio is
  five. For each percentage point that inflation
  is reduced, five percent of annual output must be
  sacrificed in the transition.

66
Phillips Curve (Figure 21-2)
Inflation Rate
C
6
2
Unemployment Rate
0
3
6
67
The Aggregate Demand and Aggregate Supply Model
AD Falls
Price Level
Aggregate Supply
C
B
PN
Aggregate Demand
QN
Quantity of Output
68
Phillips Curve (Figure 21-2)
Inflation Rate
C
6
B
2
Unemployment Rate
0
3
6
69
The Cost of Reducing InflationFed Chairman Paul
Volcker Era

• In some time periods (e.g. 1979-84) the sacrifice
  ratio was very large indicating a high level of
  unemployment was to be experienced in order to
  reduce inflation to acceptable levels.
• To reduce inflation from about 10 in 1979-81 to
  4 would require an estimated sacrifice of 30
  percent of annual output!
• Figures 21-10 21-11 (Volcker Disinflation)

70
Reducing Inflation

• As recession slows economy
• Actual inflation lt Expected inflation
• Eventually inflationary expectations fall
• Aggregate Supply Curve shifts right
• Economy returns to natural rate of output
  unemployment

71
The Aggregate Demand and Aggregate Supply Model
AD Falls
Price Level
Aggregate Supply
C
B
A
PN
Aggregate Demand
QN
Quantity of Output
72
Reducing Inflation

• Once economy is back to natural rate of output
  unemployment
• And actual inflation expected inflation
• Economy is back on its Long-Run Aggregate Supply
  Curve...

73
The Aggregate Demand and Aggregate Supply Model
AD Falls
Price Level
Aggregate Supply
C
B
PN
A
Aggregate Demand
QN
Quantity of Output
74
The Aggregate Demand and Aggregate Supply Model
AD Falls
Price Level
Aggregate Supply
C
B
PN
A
Aggregate Demand
LRAS
QN
Quantity of Output
75
Reducing Inflation

• Similarly, as the economy comes back to the
  natural rate of unemployment
• There is a return to the long-run Phillips Curve

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Reducing Inflation

• A new short run Phillips Curve passes through
  point A.
• Inflationary expectations are lower on this new
  (purple) Phillips Curve than on one above it
• And any change in AD will move economy in
  short-run on this new curve

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Phillips Curve (Figure 21-2)
Inflation Rate
C
6
B
2
A
Unemployment Rate
0
3
6
78
Theory Number Two

• Peoples expectations about inflation may adjust
  quickly to changes in absolute inflation..
• Bottom Line Adjustment to lower inflation rate
  may not require high unemployment

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Phillips Curve (Figure 21-2)
Inflation Rate
C
6
B
2
A
Unemployment Rate
0
3
6
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Rational Expectations

• The theory of rational expectations suggested
  that the time and therefore the sacrifice-ratio,
  could be shorter and lower than estimated.
• The theory of rational expectations suggests that
  people optimally use all the information they
  have, including information about government
  policies, when forecasting the future.

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Rational Expectations

• Expected inflation is an important variable that
  explains why there is a tradeoff between
  inflation and unemployment in the short-run, but
  not in the long run.
• How quickly the short-run tradeoff disappears
  depends on how quickly expectations adjust.

82
The Cost of Reducing InflationFed Chairman Alan
Greenspan Era

• In 1986, OPEC members abandoned their agreement
  to restrict supply, resulting in a favorable
  supply shock leading to falling inflation and
  falling unemployment. The beginning of the
  Greenspan Era.
• Fluctuations in inflation and unemployment have
  been relatively small due to Feds actions. (Fig
  21-12)

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Phillips Curve (Figure 21-2)
Inflation Rate
C
6
2
A
Unemployment Rate
0
3
6
84
The Aggregate Demand and Aggregate Supply Model
AS Falls
Price Level
Aggregate Supply
C
B
PN
A
Aggregate Demand
QN
Quantity of Output
85
Conclusion

• Our understanding of the tradeoffs between
  inflation and unemployment has changed
  dramatically over the past forty years.
• New evidence, new experiences, and additional
  analysis have lead to more agreement about this
  phenomena than in the past.

86
Costs of Controlling Inflation

• Which theory was correct.
• What were the costs of reducing inflation between
  1980 and 1982?
• The envelope please .

87
Cost of Fighting Inflation

• Check out editorial page letters to editor,
  Wall Street Journal
• Nov 1, 1982
• Nov 17, 1982

88
Cost of Fighting Inflation

• Contraction Output Lost
• 1990-91 1 week
• 1980-82 1 month
• Great Depression 2 years

89
Quick Quiz!

• What is the sacrifice ratio?
• How might the credibility of the Feds commitment
  to reduce inflation affect the sacrifice ratio?

90
Quick Quiz!

• Give an example of a favorable shock to aggregate
  supply.
• Use the model of aggregate supply and aggregate
  demand to explain the effects of such a shock.
• How does it affect the Phillips Curve?