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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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