In this chapter, look for the answers to these questions: § How are inflation and unemployment related in the
C H A P T E R
35
- - - - The Short The Short Run Trade Run Trade - off Between off Between Inflation and Unemployment Inflation and Unemployment
P R I N C I P L E S O F P R I N C I P L E S O F conomics
E N. Gregory N. Gregory Mankiw Mankiw
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In this chapter, In this chapter, look for the answers to these questions: 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?
1 Introduction In the long run, inflation & unemployment are
§ unrelated:
§ The inflation rate depends mainly on § Unemployment (the “natural rate”) depends on One of the Ten Principles:
§ In the short run, society faces a trade-off between inflation and unemployment.
2 THE SHORT-RUN TRADE-OFF
The Phillips Curve § Phillips curve :
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.”
3 THE SHORT-RUN TRADE-OFF
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.
4 THE SHORT-RUN TRADE-OFF
Deriving the Phillips Curve
A. Low agg demand, low inflation, high u-rate
P inflation SRAS PC AD
1 Y u-rate
B. High agg demand, high inflation, low u-rate
5 THE SHORT-RUN TRADE-OFF
The Phillips Curve: A Policy M enu? § Since fiscal and mon policy affect agg demand,
the PC appeared to offer policymakers a menu of choices:
§ § § anything in between § 1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.
6 THE SHORT-RUN TRADE-OFF
Evidence for the Phillips Curve?
Inflation rate (% per year)
During the 1960s,
During the 1960s,
U.S. policymakers
U.S. policymakers
10 opted for reducing
opted for reducing
unemployment 8 unemployment at the expense of
at the expense of
6 higher inflation
higher inflation
68
4
66
67
62
2
65 1961
64
63 Unemployment
2
4
6
8
10 rate (%)
7 THE SHORT-RUN TRADE-OFF The Vertical Long-Run Phillips Curve
§ 1968: Milton Friedman and Edmund Phelps
argued that
§ Natural-rate hypothesis : the claim that § Based on the classical dichotomy and the
vertical LRAS curve
8 THE SHORT-RUN TRADE-OFF
The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes faster inflation. inflation
P LRAS LRPC Y u-rate
Natural rate Natural rate of of output unemployment
9 Reconciling Theory and Evidence
Evidence (from ’60s): § PC slopes downward.
Theory (Friedman and Phelps): § PC is vertical in the long run.
§ To bridge the gap between theory and evidence, Friedman and Phelps introduced a new variable: expected inflation –
10 THE SHORT-RUN TRADE-OFF The Phillips Curve Equation Unemp.
= rate
Short run Fed can reduce u-rate below the natural u-rate by
Long run Expectations catch up to reality,
11 THE SHORT-RUN TRADE-OFF
THE SHORT-RUN TRADE-OFF
Instead, suppose the natural rate falls to 4%. Draw the new long-run Phillips curve, then repeat part B.
1
13 A C T I V E L E A R N I N G A C T I V E L E A R N I N G
1 A numerical example A numerical example
1
A C T I V E L E A R N I N G A C T I V E L E A R N I N G
12 How Expected Inflation Shifts the PC
Initially, expected & actual inflation = 3%, unemployment = natural rate (6%). u-rate inflation
Suppose expected inflation rises to 4%. Repeat part B.
C.
A Natural rate of unemployment = 5% Expected inflation = 2% In PC equation, a = 0.5 A. Plot the long-run Phillips curve.
6% 3%
1 LRPC
PC
B. Find the u-rate for each of these values of actual inflation: 0%, 6%. Sketch the short-run PC.
D.
1 Answers
1
5
Answers
14
unemployment rate in fl a ti on r a te
8
7
6
4
3
3
2
1
7
6
5
4
2
The Breakdown of the Phillips Curve
Inflation rate Early 1970s:
(% per year) unemployment increased, despite higher inflation.
10 Friedman &
8 Phelps’ explanation:
73
6 expectations
71
69
70 68 were catching
4
72
66 up with reality.
67
62
2
65 1961
64
63 Unemployment
2
4
6
8
10 rate (%)
15 THE SHORT-RUN TRADE-OFF PC
A nother Shifter: Supply Shocks :
§ Supply shock Example: large increase in oil prices
§
16 THE SHORT-RUN TRADE-OFF How an A dverse Supply Shock Shifts the PC
P inflation SRAS
1 A
A
P
1 AD PC
1 Y Y u-rate
1
17 THE SHORT-RUN TRADE-OFF
The Fed chose to accommodate the first shock in 1973 with faster money growth.
THE SHORT-RUN TRADE-OFF
18 The 1970s Oil Price Shocks
80
75
76
77
78
79
20 The Cost of Reducing Inflation §
81 THE SHORT-RUN TRADE-OFF
73
Disinflation : §
To reduce inflation, §
Short run: §
Long run:
74
1972
Result: 1979: Oil prices surged again, worsening the Fed’s tradeoff. 38.00 1/1981 32.50 1/1980 14.85 1/1979 10.11 1/1974
6
$ 3.56 1/1973 Oil price per barrel
19 The 1970s Oil Price Shocks
Inflation rate (% per year)
Unemployment rate (%)
2
4
8
Supply shocks & rising expected inflation worsened the PC tradeoff.
10
2
4
6
8
10 Supply
shocks & rising expected inflation worsened the PC tradeoff.
THE SHORT-RUN TRADE-OFF
Disinflationary M onetary Policy
Contractionary monetary policy moves economy inflation from A to B.
LRPC
Over time, A
PC
1
u-rate natural rate of unemployment
21 THE SHORT-RUN TRADE-OFF The Cost of Reducing Inflation
§ Disinflation requires enduring a period of
:
§ Sacrifice ratio § Typical estimate of the sacrifice ratio: 5 § To reduce inflation rate 1%,
must sacrifice § Can spread cost over time, e.g. To reduce inflation by 6%, can either sacrifice
§ § sacrifice
22 THE SHORT-RUN TRADE-OFF Rational Expectations, Costless Disinflation?
Rational expectations : a theory according to § which Early proponents:
§ Robert Lucas, Thomas Sargent, Robert Barro
§ Implied that disinflation could be
23 THE SHORT-RUN TRADE-OFF
Rational Expectations, Costless Disinflation? § Suppose the Fed convinces everyone it is committed to reducing inflation.
§ Then, Result:
§
24 THE SHORT-RUN TRADE-OFF The V olcker 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 had to be very contractionary to reduce inflation.
§ Success:
25 THE SHORT-RUN TRADE-OFF The V olcker Disinflation
Inflation rate Disinflation turned out to be very costly
Disinflation turned out to be very costly
(% per year) 10 u-rate
81 u-rate
80
near 10%
near 10% 1979
8 in 1982-83
in 1982-83
82
6
84
4
83
85
87
2
86 Unemployment
2
4
6
8
10 rate (%)
26 THE SHORT-RUN TRADE-OFF
The Greenspan Era § 1986: Oil prices fell 50%.
§ 1989-90: Unemployment fell, inflation rose.
Fed raised interest rates, caused a mild recession.
§ 1990s: Alan Greenspan Chair of FOMC, Unemployment and inflation fell. Aug 1987 – Jan 2006
§ 2001: Negative demand shocks created the first recession in a decade.
Policymakers responded with expansionary monetary and fiscal policy.
27 THE SHORT-RUN TRADE-OFF
The Greenspan Era
Inflation rate (% per year)
Inflation and unemployment
Inflation and unemployment
were low during most of
were low during most of
10 Alan Greenspan’s years
Alan Greenspan’s years as Fed Chairman.
8 as Fed Chairman.
6
90
05
4
1987
06 2000
92
2
94
98
96
02 Unemployment
2
4
6
8
10 rate (%)
28 THE SHORT-RUN TRADE-OFF Ben Bernanke’s challenges
§ Aggregate demand shocks:
Aggregate supply shocks:
§ §
Corn per bushel: $2.10 in 2005-06, $5.76 in 5/2008
§
Oil per barrel: $35 in 2/2004, $134 in 6/2008
§ From 6/2007 to 6/2008, § unemployment rose from 4.6% to 5.5% § CPI inflation rose from 2.6% to 4.9%
CONCLUSION § The theories in this chapter come from some of th the greatest economists of the 20 century.
§ They teach us that inflation and unemployment are
§ § § affected by expectations,
which play an important role in