16 The Trade-off Between Inflation and Unemployment We must seek to reduce inflation at a lower cost...

1616

The Trade-off Between Inflation and

UnemploymentWe must seek to reduce inflation at a lower cost in

lost output and unemployment.JIMMY CARTER

The Trade-off Between Inflation and

UnemploymentWe must seek to reduce inflation at a lower cost in

lost output and unemployment.JIMMY CARTER

● Demand-Side Inflation versus Supply-Side Inflation: A Review

● Origins of the Phillips Curve

● Supply-Side Inflation and the Collapse of the Phillips Curve

● What the Phillips Curve Is Not

● Demand-Side Inflation versus Supply-Side Inflation: A Review

● Origins of the Phillips Curve

● Supply-Side Inflation and the Collapse of the Phillips Curve

● What the Phillips Curve Is Not

ContentsContents

Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

● Fighting Unemployment with Fiscal and Monetary Policy

● What Should Be Done?

● Inflationary Expectations and the Phillips Curve

● The Theory of Rational Expectations

● Why Economists (and Politicians) Disagree

● Fighting Unemployment with Fiscal and Monetary Policy

● What Should Be Done?

● Inflationary Expectations and the Phillips Curve

● The Theory of Rational Expectations

● Why Economists (and Politicians) Disagree

Contents (continued)Contents (continued)


● The Dilemma of Demand Management

● Attempts to Reduce the Natural Rate of Unemployment

● Indexing

● The Dilemma of Demand Management

● Attempts to Reduce the Natural Rate of Unemployment

● Indexing

Contents (continued)Contents (continued)


Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

AD prices output

AS prices output

AD prices output

AS prices output

Demand-Side Inflation versus Supply-Side InflationDemand-Side Inflation versus Supply-Side Inflation

FIGURE 1: Inflation from the Demand Side

FIGURE 1: Inflation from the Demand Side


S

S

D0

D0 P

ric

e L

ev

el

Real GDP

A

D1

D1

B

FIGURE 2: Inflation from the Supply Side

FIGURE 2: Inflation from the Supply Side


S0

S0

D0

D0 P

rice

Lev

el

Real GDP

A

S1

S1

B


Origins of the Phillips CurveOrigins of the Phillips Curve

● If GDP are primarily caused by AD:♦ Higher rates of inflation will be associated with

lower rates of unemployment

♦ Lower rates of inflation will be associated with higher rates of unemployment

● The U.S. data for 1954-1969 show such a relationship.

● If GDP are primarily caused by AD:♦ Higher rates of inflation will be associated with

lower rates of unemployment

♦ Lower rates of inflation will be associated with higher rates of unemployment

● The U.S. data for 1954-1969 show such a relationship.

FIGURE 3: Origins of the Phillips Curve

FIGURE 3: Origins of the Phillips Curve


3%

1%

2%

6%

A

B

Infl

atio

n R

ate

5% 4%

C

Unemployment Rate

FIGURE 5: A Phillips Curve for the U.S., 1954-1969

FIGURE 5: A Phillips Curve for the U.S., 1954-1969


7%

6

5

4

3

2

10 9 8 7 6 5 4 3 2

1961

1958 1962 1954

1959

1963 1960

1964 1967

1957 1965

1955 1956 1966

1969 1968

0 1

Infl

atio

n R

ate

1

Unemployment Rate in Percent


Supply-Side Inflation and the Collapse of Phillips CurveSupply-Side Inflation and the Collapse of Phillips Curve

● If GDP are primarily caused by AS:♦ Higher rates of inflation will be associated with

higher rates of unemployment

♦ Lower rates of inflation will be associated with lower rates of unemployment

● The U.S. data for 1972-1974 and 1978-1980 show such a relationship.

● If GDP are primarily caused by AS:♦ Higher rates of inflation will be associated with

higher rates of unemployment

♦ Lower rates of inflation will be associated with lower rates of unemployment

● The U.S. data for 1972-1974 and 1978-1980 show such a relationship.

FIGURE 6: A Phillips Curve for the U.S.?

FIGURE 6: A Phillips Curve for the U.S.?


1961

1958 1962 1954

1959

1963 1960

1964 1967

1957 1965 1955 1956

1966

1969

1968

1978 1973

1979

1974 1980

1981 1975

1983

1982

1977

1971

1970 1972

1984

1976

12%

11

10

9

8

7

6

5

4

3

2

10 9 8 7 6 5 4 3 2 0 1

Infl

ati

on

Ra

te

1



Supply-Side Inflation and the Collapse of Phillips CurveSupply-Side Inflation and the Collapse of Phillips Curve

● Explaining the Fabulous 1990s♦ Favorable supply shock AS curve shifts out

♦ Characterizes the U.S. economy from 1996 to 1998■GDP grew rapidly■Both inflation and unemployment fell

● Explaining the Fabulous 1990s♦ Favorable supply shock AS curve shifts out

♦ Characterizes the U.S. economy from 1996 to 1998■GDP grew rapidly■Both inflation and unemployment fell


FIGURE 7: The Effects of a Favorable Supply Shock

FIGURE 7: The Effects of a Favorable Supply Shock


Pri

ce

Le

ve

l

Real GDP

Effect of favorable supply shock

N ormal growth of aggregate supply

D0

D0

S0

S0 D1

D1

S1

S1

B

C

A


What the Phillips Curve Is NotWhat the Phillips Curve Is Not

● Phillips Curve = curve showing a short-run trade-off between unemployment and inflation♦ Only applies if AD

♦ Not a stable, long-run menu of choices

● Phillips Curve = curve showing a short-run trade-off between unemployment and inflation♦ Only applies if AD

♦ Not a stable, long-run menu of choices

FIGURE 8: The Elimination of a Recessionary Gap

FIGURE 8: The Elimination of a Recessionary Gap


Pri

ce L

evel

Real GDP

S0

S0

S2

S2

S1

S1

D

D

A

B

Potential GDP

C



● In the long run, AD : inflation

♦ But AD does not unemployment

● Long-run effects due to the self-correcting mechanism of the economy

● In the long run, AD : inflation

♦ But AD does not unemployment

● Long-run effects due to the self-correcting mechanism of the economy

FIGURE 9: The Vertical Long-Run Phillips Curve

FIGURE 9: The Vertical Long-Run Phillips Curve


Infl

ati

on

Ra

te


g

c

f

e

8%

a

d 7

6

5

4

3

2

1

7 6.5 4 3.5 6 5.5 5 4.5



● Natural rate of unemployment = level of unemployment that is sustainable in the long run

● Corresponds to the “full-employment” unemployment rate

● Natural rate of unemployment = level of unemployment that is sustainable in the long run

● Corresponds to the “full-employment” unemployment rate


Fighting Unemployment with Fiscal and Monetary PolicyFighting Unemployment with Fiscal and Monetary Policy

● Policy choices if high unemployment:♦ Use expansionary fiscal and monetary policy

unemployment inflation

♦ Rely on economy’s self-correcting mechanism unemployment without inflation ■Problem: may take a long time to reduce

unemployment

● Policy choices if high unemployment:♦ Use expansionary fiscal and monetary policy

unemployment inflation

♦ Rely on economy’s self-correcting mechanism unemployment without inflation ■Problem: may take a long time to reduce

unemployment


What Should be Done?What Should be Done?

● Active versus passive monetary and fiscal policy♦ How the public rates the relative costs of

unemployment and inflation

♦ Slope of the short-run Phillips curve

♦ Efficiency of the economy’s self-correcting mechanism

● Active versus passive monetary and fiscal policy♦ How the public rates the relative costs of

unemployment and inflation

♦ Slope of the short-run Phillips curve

♦ Efficiency of the economy’s self-correcting mechanism


Inflationary Expectations and the Phillips CurveInflationary Expectations and the Phillips Curve

● Inflation does not erode real wages if:♦ Workers can see inflation coming

♦ They receive compensation for it

● But if real wages do not fall, firms have no incentives to increase production.

● Inflation does not erode real wages if:♦ Workers can see inflation coming

♦ They receive compensation for it

● But if real wages do not fall, firms have no incentives to increase production.

TABLE 1: Money & Real Wages under Unexpected Inflation

TABLE 1: Money & Real Wages under Unexpected Inflation


TABLE 2: Money and Real Wages under Expected Inflation

TABLE 2: Money and Real Wages under Expected Inflation



● When inflation is predicted accurately:♦ The short-run AS curve is vertical at potential

GDP

♦ The short-run Phillips curve is vertical at the natural rate of unemployment

● When inflation is underestimated:♦ The short-run AS curve and the short-run

Phillips curve slope upward

● When inflation is predicted accurately:♦ The short-run AS curve is vertical at potential

GDP

♦ The short-run Phillips curve is vertical at the natural rate of unemployment

● When inflation is underestimated:♦ The short-run AS curve and the short-run

Phillips curve slope upward

Inflationary Expectations and the Phillips CurveInflationary Expectations and the Phillips Curve

FIGURE 10: Vertical AS Curve and the Vertical Phillips Curve

FIGURE 10: Vertical AS Curve and the Vertical Phillips Curve


Vertical short-run Phillips curve

Infl

ati

on

Ra

te

(b)

Unemployment Rate

Vertical aggregate supply curve P

ric

e L

ev

el

(a)

Real GDP 5 S

S


● Rational expectations = forecasts that are the best that can be made given the available data♦ Not necessarily correct

♦ No systematic errors

● Rational expectations = forecasts that are the best that can be made given the available data♦ Not necessarily correct

♦ No systematic errors

The Theory of Rational ExpectationsThe Theory of Rational Expectations



● If expectations of inflation are rational:♦ The short-run Phillips Curve is vertical

♦ Inflation can be reduced without the need for a period of high unemployment

● If expectations of inflation are rational:♦ The short-run Phillips Curve is vertical

♦ Inflation can be reduced without the need for a period of high unemployment



● Reasons that expectations are not completely rational♦ Contracts may embody outdated expectations

♦ Expectations may adjust slowly

♦ Workers likely receive compensation for inflation after the fact

● Reasons that expectations are not completely rational♦ Contracts may embody outdated expectations

♦ Expectations may adjust slowly

♦ Workers likely receive compensation for inflation after the fact



● In the long run, expectations should be rational.♦ People should not cling to incorrect

expectations indefinitely.

● In the long run, expectations should be rational.♦ People should not cling to incorrect

expectations indefinitely.


Why Economists (and Politicians) DisagreeWhy Economists (and Politicians) Disagree

● Why Keynesians and liberals are more eager to fight unemployment♦ Unemployment is more costly than inflation

♦ The short-run Phillips Curve is flat

♦ Expectations react sluggishly

♦ The self-correcting mechanism is slow or unreliable

● Why Keynesians and liberals are more eager to fight unemployment♦ Unemployment is more costly than inflation

♦ The short-run Phillips Curve is flat

♦ Expectations react sluggishly

♦ The self-correcting mechanism is slow or unreliable


Why Economists (and Politicians) DisagreeWhy Economists (and Politicians) Disagree

● Why rational expectations, adherents, and conservatives are more eager to fight inflation♦ Inflation is more costly than unemployment

♦ The short-run Phillips curve is steep

♦ Expectations react quickly

♦ The economy’s self-correcting mechanism works smoothly and rapidly

● Why rational expectations, adherents, and conservatives are more eager to fight inflation♦ Inflation is more costly than unemployment

♦ The short-run Phillips curve is steep

♦ Expectations react quickly

♦ The economy’s self-correcting mechanism works smoothly and rapidly


The Dilemma of Demand ManagementThe Dilemma of Demand Management

● Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment.♦ True whether inflation is due to a shock to AD

or AS

♦ Government only has control over AD curve

● Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment.♦ True whether inflation is due to a shock to AD

or AS

♦ Government only has control over AD curve


Attempts to Reduce Natural Rate of UnemploymentAttempts to Reduce Natural Rate of Unemployment

● The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment.♦ Education

♦ Training

♦ Job placement services

● The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment.♦ Education

♦ Training

♦ Job placement services


Attempts to Reduce Natural Rate of UnemploymentAttempts to Reduce Natural Rate of Unemployment

● Problems♦ Training and placement programs often look

better on paper than they do in practice, where they achieve only modest successes.

♦ The high cost of these programs restricts the number of workers that can be accommodated, even when they work.

● Problems♦ Training and placement programs often look

better on paper than they do in practice, where they achieve only modest successes.

♦ The high cost of these programs restricts the number of workers that can be accommodated, even when they work.


IndexingIndexing

● Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes♦ Wages

♦ Pensions

♦ Interest payments on bonds

♦ Income taxes

● Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes♦ Wages

♦ Pensions

♦ Interest payments on bonds

♦ Income taxes


IndexingIndexing

● Indexing protects people from the costs of inflation.

● But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it.

● Indexing protects people from the costs of inflation.

● But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it.

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