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Chapter 33

Chapter 33. The Trade-Off between Inflation and Unemployment. We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER. Trade-off: Inflation & Unemployment. High-growth policies Reduce unemployment Tend to raise inflation Slow-growth policies

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Chapter 33

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  1. Chapter 33 The Trade-Off between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER

  2. Trade-off: Inflation & Unemployment • High-growth policies • Reduce unemployment • Tend to raise inflation • Slow-growth policies • Reduce inflation • Tend to raise unemployment • Aggregate supply curve • Fairly flat in short run • Quite steep in long run

  3. Demand-side vs. Supply-side Inflation • Major source of inflation • Rapid growth of aggregate demand • C, I, G, X-IM • Multiplier effect • Inflation & increased output • Demand-side inflation = rise in price level • Cause: rapid growth of aggregate demand • Accompanied: rapid growth in real GDP

  4. Figure 1 Inflation from the demand side D1 D0 S B A Price Level D0 D1 S Real GDP

  5. Demand-side vs. Supply-side Inflation • Source of inflation • Factors - retard growth of aggregate supply • Aggregate supply – inward shift • Inflation & decrease in output • Stagflation • Supply-side inflation = rise in price level • Cause: slow growth or decline of aggregate supply • Accompanied by stagnant/or falling GDP

  6. Figure 2 Inflation from the supply side D0 B S0 S1 A Price Level D0 S0 S1 Real GDP

  7. Origins of the Phillips Curve • Business fluctuations – from demand • Inverse relationship • Unemployment • Inflation • Faster growth of real output • Faster growth - number of jobs • Lower unemployment • Slower growth of real output • Slower growth - number of jobs • Higher unemployment

  8. Figure 3 Origins of the Phillips Curve B A C Inflation Rate 2 1 3 0 4% 6% 5% Unemployment rate

  9. Origins of the Phillips Curve • Phillips curve - graph • Horizontal axis - rate of unemployment • Vertical axis • Rate of inflation • Rate of change in money wages • Downward-sloping • Higher inflation rates • Lower unemployment rates

  10. Figure 4 The original Phillips Curve

  11. Origins of the Phillips Curve • Phillips curve • Short-run trade-off • Inflation & unemployment • Fits data • U.S. post WWII • 1960s and 1970s • Doesn’t fit data: 1970s, 1980s • High unemployment • High inflation

  12. Figure 5 A Phillips Curve for the United States, 1954–1969

  13. Figure 6 A Phillips Curve for the United States?

  14. Supply-side Inflation & Phillips Curve • Inflation 1972 – 1982 • Adverse supply shocks • Crop failures 1972-1973 • Oil price increases • 1973-1974 • 1979-1980 • Prices rise • Output falls • Rise in unemployment

  15. Supply-side Inflation & Phillips Curve • Business fluctuations – from supply • Higher rates of inflation • Higher rates of unemployment • Lower rates of inflation • Lower rates of unemployment

  16. Supply-side Inflation & Phillips Curve • 1996-1998 • Favorable supply shocks • Oil prices – plummeted • Advances in technology • Value of U.S. dollar – rise • Aggregate demand – shift outward • Aggregate supply – shift outward more • Rapid growth • Reduce unemployment • Inflation – falls

  17. Figure 7 S0 The effects of a favorable supply shock S1 Normal growth of aggregate supply Effect of favorable supply shock C A B D0 D1 Price Level D0 D1 S1 S0 Real GDP

  18. What the Phillips Curve is Not • Phillips curve • Statistical relationship • Inflation & unemployment • Business fluctuations – from demand • 1970s, 1980s • Misinterpretation • Alternative equilibrium points

  19. What the Phillips Curve is Not • Self-correcting mechanism • No government intervention • Corrects inflationary gap • Inward shift – aggregate supply • Corrects recessionary gap • Outward shift – aggregate supply

  20. Figure 8 The elimination of a recessionary gap Potential GDP S0 S1 S2 A B C Price Level D D S0 S1 S2 Real GDP

  21. What the Phillips Curve is Not • Phillips curve diagram • Inflationary gap points • High inflation & low unemployment • Cannot be maintained indefinitely • Lead: rising unemployment & rising inflation • Recessionary gap points • Low inflation & high unemployment • Cannot be maintained indefinitely • Lead: falling inflation & falling unemployment

  22. Figure 9 The vertical long-run Phillips Curve 8% 7 6 5 Inflation Rate 4 d a e f g 3 c 2 1 0 3.5 4 4.5 5 5.5 6 6.5 7 Unemployment Rate in Percent

  23. What the Phillips Curve is Not • Economy’s self-correcting mechanism • Push unemployment rate • Toward a specific rate of unemployment • “Natural rate of unemployment” • Vertical (long-run) Phillips curve • Points: inflation & unemployment • Choices available to society in long run • Vertical straight line • At natural rate of unemployment

  24. Trade-off: inflation & unemployment • Short run • “Ride up the Phillips curve” • Lower levels of unemployment • Stimulate aggregate demand • “Ride down the Phillips curve” • Lower rates of inflation • Restrict growth of aggregate demand

  25. Trade-off: inflation & unemployment • Short run • Trade-off between unemployment & inflation • Stimulate demand • Lower unemployment • Worsen inflation • Restricting demand • Lower inflation • Worsen unemployment problem

  26. Trade-off: inflation & unemployment • Long run • No trade-off • Economy’s self-correcting mechanism • Unemployment - Natural rate • Faster growth of demand • Higher inflation • Not lower unemployment • Slower growth of demand • Lower inflation • Not higher unemployment

  27. Fighting Unemployment: Fiscal & Monetary • Recessionary gap, 2001 • Self-correcting mechanism • Decline unemployment & inflation • May take too long • Expansionary monetary policy • The Fed – cut interest rates • Expansionary fiscal policy • Increase spending (defense & security) • Tax cut • Faster recovery & higher inflation rate

  28. What Should Be Done ? • Reduce unemployment more rapidly • Expansionary fiscal & monetary policies • Permanently higher inflation rate • Policy makers • Costs of inflation & unemployment • Slope of short run Phillips curve • Efficiency of economy’s self-correcting mechanism

  29. Inflationary Expectations & Phillips Curve • Aggregate supply curve – slopes upward • Business • Long-term contacts: labor, inputs • Fixed input cost (money) • Prices of goods – rise • Real wages – fall • Labor – cheaper in real terms • Expand employment & output

  30. Table 1 Money and real wages under unexpected inflation

  31. Inflationary Expectations & Phillips Curve • Fixed money wage – long-term contract • Inflation: Lower real wage • Firms: increase production & employment • Compensation for inflation • Increasing real wage • Firms: no incentive to increase production • Aggregate supply: vertical line • Potential GDP

  32. Table 2 Money and real wages under expected inflation

  33. Figure 10 Vertical aggregate supply curve & corresponding vertical Phillips Curve S Vertical short-run Phillips curve Vertical aggregate supply curve Price Level Inflation Rate S 5 Real GDP Unemployment Rate (b) (a)

  34. Inflationary Expectations & Phillips Curve • Vertical aggregate supply curve • Leads: vertical Phillips curve • Short-run Phillips curve - vertical • Inflation – predicted accurately • Short-run aggregate supply curve • Vertical

  35. Inflationary Expectations & Phillips Curve • Inflation – underestimated • Aggregate supply curve – upward sloping • Unexpectedly high inflation • Reduce real wages • Raise output • Unexpected decline in inflation • Recession

  36. Inflationary Expectations & Phillips Curve • Fail to anticipate inflation correctly • Phillips curve • Slopes downward in short run • Vertical in long run

  37. Theory of Rational Expectations • Rational expectations • Forecasts • Not necessarily correct • Best that can be made • Given - available data • Cannot err systematically • Forecasting errors • Pure random numbers

  38. Theory of Rational Expectations • Rational expectations • Optimal use • Available information • If expectations are rational • Inflation-Expected inflation= A random number • Short run Phillips curve – vertical • Reduce inflation • No decrease in output • No high unemployment • No trade-off (inflation & unemployment)

  39. Theory of Rational Expectations • Reject extreme rational expectations • Contacts – outdated expectations • Expectations – adjust slow • Wages – catch up with inflation • Facts

  40. Why Economists (& Politicians) Disagree • Believers in rational expectations • Believes • Inflation - more costly than unemployment • Short-run Phillips curve – steep • Expectations react quickly • Self-correcting mechanism of economy • Works smoothly and rapidly • Government intervention • Prevent / reduce inflation • Don’t want to fight recessions

  41. Why Economists (& Politicians) Disagree • Keynesian economists • Believes • Unemployment - more costly than inflation • Short-run Phillips curve – flat • Expectations react sluggishly • Self-correcting mechanism • Slow & unreliable • No government intervention • Prevent / reduce inflation (inflationary gap) • Eager to fight recessions

  42. Dilemma of Demand Management • Shifts of aggregate supply curve • Inflation & unemployment • Rise or fall together • Destroy statistical Phillips curve relationship • Monetary & fiscal policy • Shifts aggregate demand curve • Unemployment & inflation • Move in opposite directions

  43. Dilemma of Demand Management • Monetary & fiscal policy authorities • Trade-off: inflation & unemployment • No matter – source of inflation • No matter – Phillips curve

  44. Reduce Natural Rate of Unemployment • Reduce natural rate of unemployment • Lower unemployment • No increase in inflation • Education, training, job placement • Problems • Look better on paper • High cost • Work experience

  45. Indexing • Indexing - provisions in a law / contract • Monetary payments • Automatically adjusted • When price index – changes • Escalator clauses • Wage rates, pensions, • Interest payments on bonds, income taxes • Seeks to reduce: social costs of inflation

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