22 The Short-Run Trade-off Between

Inflation and Unemployment

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, look for the answers to
these questions:
 How are inflation and unemployment related in the
short run? In the long run?
 What factors alter this relationship?
 What is the short-run cost of reducing inflation?
 Why were U.S. inflation and unemployment both
so low in the 1990s?

CHAPTER 35 THE SHORT-RUN TRADE-OFF 2

 Introduction
 In the long run, inflation & unemployment are
unrelated:
• The inflation rate depends mainly on growth in
the money supply.
• Unemployment (the “natural rate”) depends on
the minimum wage, the market power of unions,
efficiency wages, and the process of job search.
 In the short run,
society faces a trade-off between
inflation and unemployment.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 3

 The Phillips Curve
 Phillips curve: shows the short-run trade-off
between inflation and unemployment
 1958: A.W. Phillips showed that
nominal wage growth was negatively
correlated with unemployment in the U.K.
 1960: Paul Samuelson & Robert Solow found
a negative correlation between U.S. inflation
& unemployment, named it “the Phillips Curve.”

CHAPTER 35 THE SHORT-RUN TRADE-OFF 4

 Deriving the Phillips Curve
 Suppose P = 100 this year.
 The following graphs show two possible
outcomes for next year:
A. Agg demand low,
small increase in P (i.e., low inflation),
low output, high unemployment.
B. Agg demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 5

 Deriving the Phillips Curve
A. Low agg demand, low inflation, high u-rate
P inflation

SRAS
B B
5%
105
A
103 3% A
AD2
PC
AD1

Y1 Y2 Y 4% 6% u-rate

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

CHAPTER 35 THE SHORT-RUN TRADE-OFF 6
 The Phillips Curve: A Policy Menu?
 Since fiscal and mon policy affect agg demand,
the PC appeared to offer policymakers a menu
of choices:
• low unemployment with high inflation
• low inflation with high unemployment
• anything in between
 1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 7

 Evidence for the Phillips Curve?
During the 1960s,
U.S. policymakers
opted for reducing
unemployment
at the expense of
higher inflation

CHAPTER 35 THE SHORT-RUN TRADE-OFF 8

 The Vertical Long-Run Phillips Curve

 1968: Milton Friedman and Edmund Phelps

argued that the tradeoff was temporary.
 Natural-rate hypothesis: the claim that
unemployment eventually returns to its normal or
“natural” rate, regardless of the inflation rate
 Based on the classical dichotomy and the
vertical LRAS curve.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 9

 The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes
faster inflation.
P inflation
LRAS LRPC

high
P2 infla-
tion
P1 AD2 low
infla-
AD1 tion
Y u-rate
natural rate natural rate of
unemployment
CHAPTER 35 THE SHORT-RUN TRADE-OFF 10
of output
 Reconciling Theory and Evidence
 Evidence (from ’60s):
PC slopes downward.
 Theory (Friedman and Phelps’ work):
PC is vertical in the long run.
 To bridge the gap between theory and evidence,
Friedman and Phelps introduced a new variable:
expected inflation – a measure of how much
people expect the price level to change.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 11

 The Phillips Curve Equation
Natural
Unemp.
= rate of – a Actual – Expected
rate inflation inflation
unemp.

Short run
Fed can reduce u-rate below the natural u-rate
by making inflation greater than expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate whether inflation
is high or low.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 12

 How Expected Inflation Shifts the PC
Initially, expected &
actual inflation = 3%,
inflation
unemployment = LRPC
natural rate (6%).
Fed makes inflation
2% higher than expected, B C
5%
u-rate falls to 4%.
In the long run, 3% A
expected inflation PC2
increases to 5%, PC1
PC shifts upward,
unemployment returns to 4% 6% u-rate
its natural rate.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 13

A C T I V E L E A R N I N G 1:
Exercise
Natural rate of unemployment = 5%
Expected inflation = 2%
Coefficient a in PC equation = 0.5
A. Plot the long-run Phillips curve.
B. Find the u-rate for each of these values of actual
inflation: 0%, 6%. Sketch the short-run PC.
C. Suppose expected inflation rises to 4%.
Repeat part B.
D. Instead, suppose the natural rate falls to 4%.
Draw the new long-run Phillips curve,
then repeat part B.
14
A C T I V E L E A R N I N G 1:
LRPCD
Answers
PCB LRPCA
7
An increase
in expected 6
inflation 5
shifts PC to inflation rate
the right. 4
PCD
3
PCC
A fall in the 2
natural rate
1
shifts both
curves 0
to the left. 0 1 2 3 4 5 6 7 8
unemployment rate
15
 The Breakdown of the Phillips Curve

Early 1970s:
unemployment increased,
despite higher inflation.
Friedman & Phelps’
explanation:
expectations were
catching up with
reality.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 16

 Another PC Shifter: Supply Shocks
 Supply shock:
an event that directly alters firms’ costs and
prices, shifting the AS and PC curves
 Example: large increase in oil prices

CHAPTER 35 THE SHORT-RUN TRADE-OFF 17

How an Adverse Supply Shock Shifts the PC
SRAS shifts left, prices rise, output & employment fall.
P inflation
SRAS2

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.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 18
 The 1970s Oil Price Shocks

Oil price per barrel The Fed chose to

1/1973 $ 3.56 accommodate the
first shock in 1973
1/1974 10.11
with faster money growth.
1/1979 14.85
Result:
1/1980 32.50
Higher expected inflation,
1/1981 38.00 which further shifted PC.
1979:
Oil prices surged again,
worsening the Fed’s tradeoff.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 19

 The 1970s Oil Price Shocks

Supply shocks & rising expected

inflation worsened the PC tradeoff.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 20

 The Cost of Reducing Inflation
 Disinflation: a reduction in the inflation rate
 To reduce inflation,
Fed must slow the rate of money growth,
which reduces agg demand.
 Short run: output falls and unemployment rises.
 Long run: output & unemployment return to
their natural rates.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 21

 Disinflationary Monetary Policy
Contractionary monetary
policy moves economy inflation
from A to B. LRPC
Over time,
expected inflation falls, A
PC shifts downward.
B
In the long run, C
point C: PC1
the natural rate PC2
of unemployment,
and lower inflation. u-rate
natural rate of
unemployment
CHAPTER 35 THE SHORT-RUN TRADE-OFF 22
 The Cost of Reducing Inflation
 Disinflation requires enduring a period of
high unemployment and low output.
 Sacrifice ratio: the number of percentage points
of annual output lost in the process of reducing
inflation by 1 percentage point
 Typical estimate of the sacrifice ratio: 5
• Reducing inflation rate 1% requires a sacrifice
of 5% of a year’s output.
 This cost can be spread over time. Example:
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, Costless Disinflation?
 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…

CHAPTER 35 THE SHORT-RUN TRADE-OFF 24

Rational Expectations, Costless Disinflation?
 Suppose the Fed convinces everyone it is
committed to reducing inflation.
 Then, expected inflation falls,
the short-run PC shifts downward.
 Result:
Disinflations can cause less unemployment
than the traditional sacrifice ratio predicts.

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 The Volcker Disinflation
Fed Chairman Paul Volcker
• appointed in late 1979 under high inflation &
unemployment
• changed Fed policy to disinflation
1981-1984:
• Fiscal policy was expansionary,
so Fed policy needed to be very contractionary
to reduce inflation.
• Success: Inflation fell from 10% to 4%,
but at the cost of high unemployment…

CHAPTER 35 THE SHORT-RUN TRADE-OFF 26

 The Volcker Disinflation
Disinflation turned out to be very costly:

u-rate near
10% in
1982-83

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 The Greenspan Era: 1987-2006

Inflation and unemployment

were low during most of
Alan Greenspan’s years
as Fed Chairman.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 28

 1990s: The End of the Phillips Curve?
 During the 1990s, inflation fell to about 1%,
unemployment fell to about 4%.
Many felt PC theory was no longer relevant.
 Many economists believed the Phillips curve
was still relevant; it was merely shifting down:
• Expected inflation fell due to the policies of
Volcker and Greenspan.
• Three favorable supply shocks occurred.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 29

 Favorable Supply Shocks in the ’90s
 Declining commodity prices
(including oil)
 Labor-market changes
(reduced the natural rate of unemployment)
 Technological advance
(the information technology boom of 1995-2000)

CHAPTER 35 THE SHORT-RUN TRADE-OFF 30

 CONCLUSION
 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
• are negatively related in the short run
• are affected by expectations, which play an
important role in the economy’s adjustment
from the short-run to the long run.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 31

CHAPTER SUMMARY
 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.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 32

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.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 33