The Short-Run Tradeoff between Inflation and Unemployment Chapter 33 Copyright © 2001 by Harcourt, Inc All rights reserved Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777 Unemployment and Inflation ◆ The natural rate of unemployment depends on various features of the labor market ◆ Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Unemployment and Inflation ◆ The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed ◆ The misery index, one measure of the “health” of the economy, adds together the inflation rate and unemployment rate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Unemployment and Inflation Society faces a short-run tradeoff between unemployment and inflation ◆ If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation ◆ If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment ◆ Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Phillips Curve The Phillips curve illustrates the short-run relationship between inflation and unemployment Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Phillips Curve Inflation Rate (percent per year) B A Phillips curve Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Unemployment Rate (percent) Aggregate Demand, Aggregate Supply, and the Phillips Curve ◆ The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Aggregate Demand, Aggregate Supply, and the Phillips Curve The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level ◆ A higher level of output results in a lower level of unemployment ◆ Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply (a) The Model of AD and AS Price Level Short-run AS 102 Inflation Rate (percent per year) B 106 A 7,500 (unemployment is 7%) (b) The Phillips Curve High AD B Low AD 8,000 (unemployment is 7%) A (output is (output is 8,000) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 7,500) Phillips curve Unemployment Rate (percent) Shifts in the Phillips Curve: The Role of Expectations The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Summary When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve ◆ This results in temporarily high unemployment ◆ The cost of disinflation depends on how quickly expectations of inflation fall ◆ Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Summary ◆ ◆ Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy Changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Graphical Review Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Phillips Curve Inflation Rate (percent per year) B A Phillips curve Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Unemployment Rate (percent) How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply (a) The Model of AD and AS Price Level Short-run AS 102 Inflation Rate (percent per year) B 106 A 7,500 (unemployment is 7%) (b) The Phillips Curve High AD B Low AD 8,000 (unemployment is 7%) A (output is (output is 8,000) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 7,500) Phillips curve Unemployment Rate (percent) The Long-Run Phillips Curve Inflation Rate When the Fed increases the growth rate of the money supply, the rate of inflation increases… High inflation Low inflation Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Long-run Phillips curve B A Natural rate of unemployment … but unemployment remains at its natural rate in the long run Unemployment Rate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply… (a) The Model of Aggregate Demand and Aggregate Supply Price Level Long-run aggregate supply (b) The Phillips Curve Inflation Rate P2 An increase in the money supply increases aggregate demand… P1 AD2 Long-run Phillips curve B …and increases the inflation rate… A Aggregate demand, AD1 …raises the price level… Natural rate of output Quantity of Output Natural rate of unemployment …but leaves output and unemployment at their natural rates Unemployment Rate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc How Expected Inflation Shifts the Short-Run Phillips Curve Inflation Rate Long-run Phillips curve B Expansionary policy moves the economy up along the shortrun Phillips curve …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right C Short-run Phillips curve with high expected inflation A Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment Rate The Phillips Curve in the 1960s Inflation Rate (percent per year) 10 1968 1967 1966 1965 1962 1964 1963 1961 Unemployment Rate (percent) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 10 The Breakdown of the Phillips Curve Inflation Rate (percent per year) 10 1973 1969 1968 1967 1971 1970 1972 1966 1965 1962 1964 1963 1961 Unemployment Rate (percent) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 10 An Adverse Shock to Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level …and raises the price level… AS2 P2 Inflation Rate Aggregate supply, AS1 A A PC2 Aggregate demand Y2 Y1 Quantity of Output …lowers output… Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc …giving policymakers a less favorable tradeoff between unemployment and inflation B An adverse shift in aggregate supply… B P1 (b) The Phillips Curve Phillips curve, PC1 Unemployment Rate The Supply Shocks of the 1970s Inflation Rate (percent per year) 10 1974 1981 1979 1978 1977 1973 1980 197 1976 1972 2 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 10 Unemployment Rate (percent) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Disinflationary Monetary Policy in the Short Run and the Long Run Inflation Rate Long-run Phillips curve A Contractionary policy moves the economy down along the shortrun Phillips curve Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment Rate but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left The Volcker Disinflation Inflation Rate (percent per year) 10 A 1980 1981 1979 1982 1984 B 1987 1983 1985 C 1986 2 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 10 Unemployment Rate (percent) The Greenspan Era Inflation Rate (percent per year) 10 1990 1991 1989 1984 1988 1985 1987 1992 1995 1994 1993 1986 00 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 10 Unemployment Rate (percent)