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The Short-Run Tradeoff between Inflation and Unemployment
Copyright ? 2004 South-Western

35

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. ? The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.
Copyright ? 2004 South-Western

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.
Copyright ? 2004 South-Western

THE PHILLIPS CURVE
? The Phillips curve illustrates the short-run relationship between inflation and unemployment.

Copyright ? 2004 South-Western

The Phillips Curve

Inflation Rate (percent per year) 6 B

2

A Phillips curve

0

4

7

Unemployment Rate (percent)
Copyright ? 2004 South-Western

The Phillips Curve and AS-AD

(a) The Model of Aggregate Demand and Aggregate Supply Price Level Short-run aggregate supply Inflation Rate (percent per year) 6

(b) The Phillips Curve

106 102 A

B

B

High aggregate demand Low aggregate demand 0 7,500 8,000 (unemployment (unemployment is 7%) is 4%)

A

2
Phillips curve 0 4 (output is 8,000)

Quantity of Output

Unemployment 7 (output is Rate (percent) 7,500)

Copyright ? 2004 South-Western

Short-Run Phillips Curve
? The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.
? But…

Copyright ? 2004 South-Western

The Long-Run Phillips Curve ? In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
? As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. ? Monetary policy could be effective in the short run but not in the long run.
Copyright ? 2004 South-Western

The Long-Run Phillips Curve

Inflation Rate

Long-run Phillips curve
B

1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .

High inflation

Low inflation

A

2. . . . but unemployment remains at its natural rate in the long run.

0

Natural rate of unemployment

Unemployment Rate

Copyright ? 2004 South-Western

The Phillips Curve and AS-AD

(a) The Model of Aggregate Demand and Aggregate Supply Price Level Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand . . . A AD2 Aggregate demand, AD 0 Natural rate of output Inflation Rate

(b) The Phillips Curve Long-run Phillips curve 3. . . . and increases the inflation rate . . . B

P2 2. . . . raises the price P level . . .

A

Quantity of Output

0

Natural rate of unemployment

Unemployment Rate

4. . . . but leaves output and unemployment at their natural rates.

Copyright ? 2004 South-Western

Expectations and the SRPC ? Expected inflation measures how much people expect the overall price level to change.

Copyright ? 2004 South-Western

Expectations and the SRPC ? In the long run, expected inflation adjusts to changes in actual inflation. ? The Fed’s ability to create unexpected inflation exists only in the short run.
? Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.
Copyright ? 2004 South-Western

Expectations and the SRPC

Unemployment Rate =
Expected Natural rate of unemployment - a Actual ? inflation inflation

?

?

Copyright ? 2004 South-Western

How Expected Inflation Shifts the SRPC
2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Long-run Phillips curve

Inflation Rate

B

C Short-run Phillips curve with high expected inflation A Short-run Phillips curve with low expected inflation Unemployment Rate
Copyright ? 2004 South-Western

1. Expansionary policy moves the economy up along the short-run Phillips curve . . .
0

Natural rate of unemployment


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