Inflation, Unemployment, and Stabilization Policies: Unemployment and the Phillips Curve

1. Inflation, Unemployment, and Stabilization Policies: Unemployment and the Phillips Curve AP Economics Mr. Bordelon

2. Short-Run Phillips Curve (SRPC) SRPC shows the relationship between inflation and unemployment rates. Note that the curve can cross 0. Using the AD-AS model, we can further elaborate on the relationship between unemployment and inflation rates. When AD increases along SRAS, unemployment rate decreases and inflation rate increases.

3. Short-Run Phillips Curve (SRPC) Using the AD-AS model, we can further elaborate on the relationship between unemployment and inflation rates. Note that a shift in AD will cause a movement along the SRPC. When AD shifts right, unemployment rate decreases and inflation rate increases. On the SRPC, this would be a movement from A to B. When AD shifts left, unemployment rate increases and inflation rate decreases. On the SRPC, this would be a movement from A to B.

4. Short-Run Phillips Curve (SRPC) With shifts of SRAS, however, we don’t see a movement along the Phillips Curve, but rather a shift of the entire Phillips Curve. When SRAS shifts right, both unemployment and inflation rates decrease. This would cause a downward shift of the SRPC. When SRAS shifts left, unemployment and inflation rate increase. This would cause an upward shift of the SRPC.

5. Inflation Expectations and SRPC The expected rate of inflation is the rate of inflation that employers and workers expect in the near future. Changes in the expected rate of inflation affect short-run relationship between unemployment and inflation and shift SRPC. Inflation affects workers and employers. If inflation is expected to be high in coming months, wage contracts reflect that expectation and nominal wages will be increased. Both workers and employers will factor expected inflation into all wage and price contracts because nobody wants to lose purchasing power due to future inflation.

6. Inflation Expectations and SRPC As a result, an increase in expected inflation shifts SRPC upward. The actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher. Macroeconomists believe that the relationship between changes in expected inflation and changes in actual inflation is one-to-one. That is, when the expected inflation rate increases, the actual inflation rate at any given unemployment rate will increase by the same amount. Why?

7. Inflation Expectations and SRPC Assume inflation has been near zero for years, but people begin to expect inflation of 3%. Nominal wages and other contracts begin to reflect a future increase of 3%. As these wages and other resource prices rise by 3%, actual inflation begins to rise from 0% to 3%. In other words, inflation expectations translate into actual inflation rates. Higher inflation expectations shift SRPC upward. At any level of unemployment, inflation will be that much higher. The converse is also true, lower inflation expectations shift SRPC downward.

8. Inflation Expectations and SRPC In the graph, an increase in expected inflation shifts SRPC upward. SRPC0 is the initial SPRC with an expected inflation rate of 0% at 6% unemployment rate. Assume an expected inflation rate of 2%. SRPC will shift upward by 2%. Each additional percentage point of expected inflation raises the actual inflation rate at any given unemployment rate by 1 percentage point. Ah, but I hear Tyler ask, wait, what about the long run?

9. Inflation and Unemployment in the Long Run • Macroeconomists believe that there is no long-run trade-off between lower unemployment rates and higher inflation rates. That is, it is not possible to achieve lower unemployment in the long run by accepting higher inflation…but why?

10. LRPC On this graph, SRPC0 is the SRPC when expected inflation is at 0%. 6% unemployment rate is the Non-accelerating inflation rate of unemployment (NAIRU)—more on this later. At a 4% unemployment rate, the economy is at point A with an actual inflation rate of 2%. The higher inflation rate will be incorporated into expectations, and SRPC will shift to SRPC2. If policymakers decide to keep unemployment at 4%, economy will be at point B and the inflation rate will increase by another 2% to 4%. Inflationary expectations will be taken into account again, and SRPC2 will shift to SRPC4. At a 4% unemployment rate, the economy will be at C and the actual inflation rate will rise to 6%, und so weiter…

11. LRPC Okay, so what? 6% is the NAIRU, which is the unemployment rate at which inflation does not change over time. As long as unemployment rate is at NAIRU, the actual inflation rate will match expectations and remain constant. An unemployment rate below 6% requires ever-accelerating inflation. LRPC, which passes through E0, E2, and E4, as a result, is vertical. No long-run trade-off between unemployment and inflation exists. Now, what about an unemployment rate above 6%? In that case, we’d be looking at disinflation.

12. LRPC Disinflation. Process of bringing down inflation that has become embedded in expectations. This is an extraordinarily painful process. Gov’t’s must use contractionary fiscal/monetary policy where the unemployment rate is above NAIRU. This would induce recession, and would decrease inflation rate to the point where SRPC shifts downward. The good news is that once inflation is under control, the economy can adjust back to the NAIRU, but at the huge cost of high unemployment. One final note on NAIRU. Recall the idea of natural rate of unemployment (frictional and structural). The natural rate is unaffected by changes in the business cycle. How does this relate to NAIRU? NAIRU is another name for the natural rate of unemployment, the level of unemployment the economy needs in order to avoid accelerating inflation is equal to the natural rate of unemployment.

13. Deflation • First off, disinflation is a decrease in the inflation rate. Deflation is the decrease in the aggregate price level. • Debt Deflation. Reduction in AD arising from increase in real burden of outstanding debt caused by deflation. • The effects of deflation on borrowers and lenders can worsen an economic slump. Deflation takes real resources away from borrowers and redistributes them to lenders. • Borrowers, who lose from deflation, are short of cash, and will be forced to cut their spending sharply when their debt burden increases. • Lenders are less likely to increase spending sharply when value of loans they own increase. • The overall effect is that deflation reduces AD, deepening the economic slump, which in turn may lead to further deflation.

14. Deflation • Effects of Expected Deflation. Interest rates are affected by inflation expectations, and to a certain extent expected deflation. • Nominal interest rate = real interest rate + expected inflation • Assume that the nominal interest rate is 4%, meaning the expected inflation rate is 0%. If the expected inflation rate is -3% then the nominal interest rate will be 1%. • But what if the expected inflation rate was -5%, what then? • The nominal interest rate would be 0%, not -1%. Why? • If lenders lent money out at a nominal interest rate of -1%, this would mean that they would be paying borrowers 1% interest on the money borrowed. Somehow, I don’t think a bank would be that generous. • Zero bound. The limit on nominal interest rates—it can not go below zero.

15. Deflation • Effects of Expected Deflation • Deflation creates a situation where lenders receive nominal interest rates that approach zero. If that’s the case, we can predict that lending will stop. • If the economy is extremely depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective. The Fed can not lower the interest rate lower than 0%. This kind of deflation can cause an economy to languish for a very long time. • Liquidity trap. Situation in which conventional monetary policy is ineffective because the nominal interest rates are up against the zero bound.

16. Deflation • Effects of Expected Deflation • Liquidity trap. Situation in which conventional monetary policy is ineffective because the nominal interest rates are up against the zero bound. • Example. Economy is depressed, with output below YP and unemployment rate above natural rate. Central bank can respond by cutting interest rates so as to increase AD. • “But wait,” said Chantal curiously, “if the nominal interest rate is already at like zero, how can the Fed cut it even more?” • The answer is, it can’t. If the nominal interest rate is already zero, no central bank can push it down further below zero. • Banks will refuse to lend and consumers and firms refuse to spend because with a negative inflation rate and a 0% nominal interest rate, holding cash yields a positive real rate of return. • Any further increases in the monetary base will either be held in bank vaults or held as cash by individuals and firms, without being spent. • This is the liquidity trap.

17. Question 1 • Given the following scenarios, describe and graph what happens to the SRPC. • Government spending increases. • The price of crude oil and most sources of energy decreases. • Inflation expectations rise from 3% to 6%. • The Fed increases interest rates with contractionary monetary policy. • Inflation expectations fall from 5% to 2%. • The government increases income taxes.