Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

1
Mankiw Brief Principles of Macroeconomics,
Second Edition (Harcourt, 2001)

• Ch. 16 The Short-run Tradeoff Between Inflation
  and Unemployment

2
Long-run Unemployment

• The natural rate of unemployment (the long-run
  unemployment rate) depends on the characteristics
  of the labor market.
• Effectiveness of job search.
• Skill gaps between labor demand and labor supply.
• Efficiency wages.
• Union power.
• Minimum wage laws.

3
Long-run Inflation

• Inflation in the long-run is strictly a monetary
  phenomenon.
• Classical Quantity Theory works in the long
  run.
• In the long-run, inflation and unemployment are
  unrelated.
• A country can have any inflation rate at the
  natural rate of unemployment.

4
Short Run

• In the short run, aggregate supply is upward
  sloping.
• Long run aggregate supply is a vertical line.
• Any shift in the aggregate demand curve will
  affect unemployment and inflation in opposite
  directions initially.
• After the adjustment of prices, unemployment will
  reach the natural rate.

5
Short-run
An increase in C or I or G or NX will shift the
AD to the right. In the short run, GDP will
increase but so will the price level. The
economy will experience a drop in the
unemployment rate but a positive inflation
rate. If the AD had shifted to the left,
inflation would have fallen, but unemployment
would have risen.
LRAS
SRAS
P3
P2
AD3
P
AD2
AD1
Y3
Y2
Y
6
Keynesian Theory

• The negative connection between inflation and
  unemployment is the logical conclusion of
  Keynesian theory.
• Prices and wages are constant in the short run.
• An increase in money supply, increases the GDP.
• But an increase in GDP (a fall in unemployment)
  will usher in an increase in the price level.

7
Phillips Curve

• In 1958, A. W. Phillips published an article
  showing the relationship between nominal wages
  and unemployment rates in Britain for a century.
• When one took the average of the observations,
  i.e., when one tried to fit a single line to
  summarize the observations, the line was downward
  sloping.
• This relationship is termed Phillips curve since.

8
Phillips Curve for the US

• Samuelson and Solow showed the same relationship
  for the US (1960).
• They used inflation rate instead of the nominal
  wage increase.
• Once this relationship is established, it made
  sense in the sixties to talk about the choice a
  government had.
• Low inflation and high unemployment
• High inflation and low unemployment

9
Unemployment and Inflation
10
Unemployment and Inflation
11
Objections to Phillips Curve

• By the end of the sixties, Friedman and Phelps
  questioned the wisdom of viewing unemployment and
  inflation trade-off in the long-run.
• They emphasized the classical dichotomy.
• Real variables cannot be influenced by monetary
  factors.
• Monetary policy will affect nominal variables.
• In the long-run, Phillips curve is vertical at
  the natural unemployment rate.

12
Long Run
Infl. rate
P
LRAS
Long run Phillips curve
SRAS
SRAS
P
AD
AD
Y
Unemp. rate
Y
U
13
How To Reconcile Phillips Curves

• The data showed downward sloping Phillips curve.
• The theory claimed vertical Phillips curve.
• In the short-run Phillips curves are downward
  sloping.
• However, there is not one but many Phillips
  curves, each one indicating a different expected
  inflation rate.

14
Short Run and Long Run
Infl. rate
P
LRAS
SRAS
SRAS
5
P
AD
SRPhC
3
AD
Long run Phillips curve
Y
Unemp. rate
Y
U
Expected inflation on the white SRPhC is 3. When
expected inflation rises to 5, SRPhC shifts to
the blue one.
15
How the Fed Can Fuel Inflation
LRPhC
4
5
7
Pe7
2
3
4
Pe4
1
1
2
Pe2
4
6
16
Inflation-Unemployment in the 1960s
17
Unemployment-Inflation 1961-73
18
Cost of Production Increase

• A shock to the economy that raises the cost of
  production in general, will shift the SRAS to the
  left.
• At the same inflation level unemployment rises,
  shifting SRPhC to the right.
• Oil price shocks of 1973 and 1980 had this
  influence on the economy.
• Oil price collapse of 1985 had the opposite
  result.

19
Oil Price Shock
LRAS
LRPhC
SRAS
SRAS
P
SRAS
6
P
5
Pe6
3
Pe5
Pe3
AD
U
Y
U
Y
20
Unemployment-Inflation 1972-81
21
Oil Price Collapse
LRPhC
LRAS
SRAS
4
SRAS
SRPhC
P
SRAS
3
P
SRPhC
SRPhC
AD
Y
Y
U
U
22
Unemployment-Inflation 1979-87
23
Unemployment-Inflation 1984-95
24
Cost of Reducing Inflation

• Suppose the economy is in long-run equilibrium
  with 10 inflation.
• Draw it.
• Suppose the Fed wants to reduce the inflation.
• What should the Fed do?
• What would be the cost to the society?

25
Cost of Reducing Inflation
LRAS
LRPhC
Pe10
SRAS
10
P
AD
AD
Y
U
26
Unemployment-Inflation 1979-87
27
Cost of Reducing Inflation

• The sacrifice the society has to go through is
  the high unemployment rate it has to endure until
  inflationary expectations are lowered to
  acceptable levels.
• The Volcker years of the Fed were severe
  unemployment period but inflation was lowered
  from two digit levels down to 4.
• The cost was supposed to be 5 drop of GDP per
  one percent of inflation drop.
• Perhaps because of rational expectations the cost
  was lower.