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TheShort-RunTrade-offBetweenInflationandUnemploymentEconomicsPRINCIPLESOFN.GregoryMankiwPremiumPowerPointSlides
byRonCronovich22Inthischapter,
lookfortheanswerstothesequestions:Howareinflationandunemploymentrelatedintheshortrun?Inthelongrun?Whatfactorsalterthisrelationship?Whatistheshort-runcostofreducinginflation?WhywereU.S.inflationandunemploymentbothsolowinthe1990s?11ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFIntroductionInthelongrun,inflation&unemploymentareunrelated:Theinflationratedependsmainlyongrowthinthemoneysupply.Unemployment(the“naturalrate”)dependsontheminimumwage,themarketpowerofunions,efficiencywages,andtheprocessofjobsearch.OneoftheTenPrinciples:
Intheshortrun,societyfacesatrade-off
betweeninflationandunemployment.2ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(1)ThePhillipsCurve03ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFThePhillipsCurvePhillipscurve:showstheshort-runtrade-offbetweeninflationandunemployment1958:A.W.Phillipsshowedthat
nominalwagegrowthwasnegatively
correlatedwithunemploymentintheU.K.1960:PaulSamuelson&RobertSolowfound
anegativecorrelationbetweenU.S.inflation
&unemployment,namedit“thePhillipsCurve.”4ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFDerivingthePhillipsCurveSupposeP=100thisyear.Thefollowinggraphsshowtwopossibleoutcomesfornextyear:A. Aggregatedemandlow,
smallincreaseinP(i.e.,lowinflation),
lowoutput,highunemployment.B. Aggregatedemandhigh,
bigincreaseinP(i.e.,highinflation),
highoutput,lowunemployment.5ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFDerivingthePhillipsCurveu-rateinflationPCA.
Lowaggregatedemand,lowinflation,highu-rateB.
Highaggregatedemand,highinflation,lowu-rateYPSRASAD1AD2Y1103A105Y2B6%3%A4%5%B6ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFThePhillipsCurve:APolicyMenu?Sincefiscalandmonetarypolicyaffectaggregatedemand,
thePhillipscurve(PC)appearedtoofferpolicymakersamenuofchoices:lowunemploymentwithhighinflationlowinflationwithhighunemploymentanythinginbetween1960s:U.S.datasupportedthePhillipscurve.
ManybelievedthePCwasstable&reliable.7ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFEvidenceforthePhillipsCurve?Inflationrate
(%peryear)Unemploymentrate(%)Duringthe1960s,U.S.policymakersoptedforreducingunemployment
attheexpenseofhigherinflation1961636562646667688ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(2)ShiftsinPhillipsCurve:RoleofExpectations09ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(A)TheVerticalLong-RunPhillipsCurve1968:MiltonFriedmanandEdmundPhelpsarguedthatthetradeoffwastemporary.Natural-ratehypothesis:theclaimthatunemploymenteventuallyreturnstoitsnormalor“natural”rate,regardlessoftheinflationrateBasedontheclassicaldichotomyandthe
verticalLRAScurve10ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFTheVerticalLong-RunPhillipsCurveu-rateinflationInthelongrun,fastermoneygrowthonlycausesfasterinflation.YPLRASAD1AD2Naturalrate
ofoutputNaturalrateofunemploymentP1P2LRPClowinfla-tionhighinfla-tion1111ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(B)ReconcilingTheoryandEvidenceEvidence(from’60s):
PCslopesdownward.Theory(FriedmanandPhelps):
PCisverticalinthelongrun.Tobridgethegapbetweentheoryandevidence,FriedmanandPhelpsintroducedanewvariable:expectedinflation–ameasureofhowmuchpeopleexpectthepriceleveltochange.12ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(C)ThePhillipsCurveEquationShortrun
TheCentralBankcanreduceu-ratebelowthenaturalu-ratebymakinginflationgreaterthanexpected.(Notethatb>0.)Longrun
Expectationscatchuptoreality(whenexpectedinflation=actualinflation),u-rategoesbacktonaturalu-ratewhetherinflationishighorlow.Unemp.rateNatural
rateofunemp.=–bActualinflationExpectedinflation–13ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(D)HowExpectedInflationShiftsthePCInitially,expected&
actualinflation=3%,
unemployment=
naturalrate(6%).CentralBankmakesinflation
2%higherthanexpected,
u-ratefallsto4%.Inthelongrun,
expectedinflationincreasesto5%,
PCshiftsupward,
unemploymentreturnstoitsnaturalrate.u-rateinflationPC1LRPC6%3%PC24%5%ABC14ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFNaturalrateofunemployment=5%
Expectedinflation=2%
InPCequation,b=0.5A.
Plotthelong-runPhillipscurve.B.
Findtheu-rateforeachofthesevaluesofactualinflation:0%,6%.Sketchtheshort-runPC.C.
Supposeexpectedinflationrisesto4%.
RepeatpartB.D.
Instead,supposethenaturalratefallsto4%.Drawthenewlong-runPhillipscurve,
thenrepeatpartB.ACTIVELEARNING1
Anumericalexample1515ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFACTIVELEARNING1
Answers16LRPCAAnincreaseinexpectedinflationshiftsPCtotheright.PCDLRPCDPCBPCCAfallinthenaturalrateshiftsbothcurves
totheleft.16ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(E)TheBreakdownofthePhillipsCurveInflationrate
(%peryear)Unemploymentrate(%)Early1970s:
unemploymentincreased,
despitehigherinflation.Friedman&Phelps’explanation:expectationswerecatching
upwithreality.196163656264666768697071727317ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(3)ShiftsinPhillipsCurve:RoleofSupplyShocks018ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFAnotherPCShifter:SupplyShocksSupplyshock:
aneventthatdirectlyaltersfirms’costsandprices,shiftingtheASandPCcurvesExample:largeincreaseinoilprices19ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFHowanAdverseSupplyShockShiftsthePCu-rateinflationSRASshiftsleft,pricesrise,output&employmentfall.Inflation&u-ratebothincreaseasthePCshiftsupward.YPSRAS1ADPC1PC2ABSRAS2AY1P1Y2BP220ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFThe1970sOilPriceShocksTheFed(U.S.CentralBank)chosetoaccommodatethe
firstshockin1973withfastermoneygrowth.Result:
Higherexpectedinflation,whichfurthershiftedPC.1979:
Oilpricessurgedagain,worseningtheFed’stradeoff.
38.001/198132.501/198014.851/197910.111/1974$3.561/1973Oilpriceperbarrel21ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFThe1970sOilPriceShocksInflationrate
(%peryear)Unemploymentrate(%)Supplyshocks&risingexpectedinflationworsenedthePCtradeoff.197273747576777879808122ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(4)TheCostofReducingInflation023ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFTheCostofReducingInflationDisinflation:areductionintheinflationrateToreduceinflation,
theFed(U.S.CentralBank)mustslowtherateofmoneygrowth,whichreducesaggregatedemand.Shortrun:
Outputfallsandunemploymentrises.Longrun:
Output&unemploymentreturntotheirnaturalrates.24ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(A)DisinflationaryMonetaryPolicyContractionarymonetarypolicymoveseconomyfromAtoB.Overtime,
expectedinflationfalls,
PCshiftsdownward.Inthelongrun,
pointC:
thenaturalrate
ofunemployment,&
lowerinflation.u-rateinflationLRPCPC1naturalrateofunemploymentAPC2CB25ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(B)SacrificeRatioDisinflationrequiresenduringaperiodof
highunemploymentandlowoutput.Sacrificeratio:
percentagepointsofannualoutputlost(overtheyears)per1percentagepointreductionininflationTypicalestimateofthesacrificeratio:5Toreduceinflationrate1%,
mustsacrifice5%ofayear’soutput.Canspreadcostovertime,e.g.
Toreduceinflationby6%,caneithersacrifice30%ofGDPforoneyearsacrifice10%ofGDPforthreeyears26ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(C)RationalExpectations,CostlessDisinflation?Rationalexpectations:atheoryaccordingtowhichpeopleoptimallyusealltheinformationtheyhave,includinginformationaboutgovernmentpolicies,whenforecastingthefutureEarlyproponents:
RobertLucas,ThomasSargent,RobertBarroImpliedthatdisinflationcouldbemuchlesscostly…27ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFRationalExpectations,CostlessDisinflation?SupposetheCentralBankconvinceseveryoneitiscommittedtoreducinginflation.Then,expectedinflationfalls,
theshort-runPCshiftsdownwardquickly.Result:
Disinflationscancauselessunemployment
thanthetraditionalsacrificeratiopredicts.Intheextremecase,itcouldbeclosetozero,whenpeopleadjustinflationexpectationimmediately.28ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(D)TheVolckerDisinflationFedChairmanPaulVolckerAppointedinlate1979underhighinflation&unemploymentChangedFedpolicytodisinflation1981-1984:Fiscalpolicywasexpansionary,
soFedpolicyhadtobeverycontractionary
toreduceinflation.Success:Inflationfellfrom10%to4%,
butatthecostofhighunemployment…29ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFTheVolckerDisinflationInflationrate
(%peryear)Unemploymentrate(%)Disinflationturnedouttobeverycostlyu-rate
near10%in1982-831979808182838485868730ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(E)TheGreenspanEra1986:Oilpricesfell50%.1989-90:
Unemploymentfell,inflationrose.
Fedraisedinterestrates,causeda
mildrecession.1990s:
Unemploymentandinflationfell.2001:Negativedemandshocks
createdthefirstrecessioninadecade.
Policymakersrespondedwithexpansionarymonetaryandfiscalpolicy.AlanGreenspan
ChairofFOMC,
Aug1987–Jan200631ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFTheGreenspanEraInflationrate
(%peryear)Unemploymentrate(%)Inflationandunemploymentwerelowduringmostof
AlanGreenspan’syears
asFedChairman.19879092200094969806020532ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFF(F)BenBernanke’schallengesAggregatedemandshocks:Subprimemortgagecrisis,fallinghousingprices,widespreadforeclosures,financialsectortroubles.Aggregatesupplyshocks:Risingpricesoffood/agriculturalcommodities,e.g., Cornperbushel:$2.10in2005-06,$5.76in5/2008Risingoilprices Oilperbarrel:$35in2/2004,$134in6/2008From6/2007to6/2008,unemploymentrosefrom4.6%to5.5%CPIinflationrosefrom2.6%to4.9%33ECON1002C/D(2011)Ch22:SHORT-RUNINF.&U-RATETRADE-OFFCONCLUSIONThetheoriesinthisc
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