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2009 South-Western,a part of Cengage Learning,all rights reservedC H A P T E RThe Short-Run Trade-off Between Inflation and UnemploymentEconomicsP R I N C I P L E S O FP R I N C I P L E S O FN.Gregory MankiwPremium PowerPoint Slides by Ron Cronovich22The Short-Run Trade-off BetweeIn this chapter,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 1 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFIn this chapter,look for the 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.IntroductionIn the long run,inflation&unemployment are unrelated:The inflation rate depends mainly on growth in the money supply.Unemployment(the“natural rate”)depends on the minimum wage,the market power of unions,efficiency wages,and the process of job search.One of the Ten Principles:In the short run,society faces a trade-off between inflation and unemployment.2 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFIntroductionIn the long run,i 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(1)The Phillips Curve3 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(1)The Phillips Curve03 ECON1 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The Phillips CurvePhillips curve:shows the short-run trade-off between inflation and unemployment 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.”4 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe Phillips CurvePhillips cur 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.Deriving the Phillips CurveSuppose P=100 this year.The following graphs show two possible outcomes for next year:A.Aggregate demand low,small increase in P(i.e.,low inflation),low output,high unemployment.B.Aggregate demand high,big increase in P(i.e.,high inflation),high output,low unemployment.5 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFDeriving the Phillips CurveSup 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.Deriving the Phillips Curveu-rateinflationPCA.Low aggregate demand,low inflation,high u-rateB.High aggregate demand,high inflation,low u-rateYPSRASAD1AD2Y1103A105Y2B6%3%A4%5%B6 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFDeriving the Phillips Curveu-r 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The Phillips Curve:A Policy Menu?Since fiscal and monetary policy affect aggregate demand,the Phillips curve(PC)appeared to offer policymakers a menu of choices:low unemployment with high inflationlow inflation with high unemploymentanything in between1960s:U.S.data supported the Phillips curve.Many believed the PC was stable&reliable.7 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe Phillips Curve:A Policy 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.Evidence for the Phillips Curve?Inflation rate(%per year)Unemployment rate(%)During the 1960s,U.S.policymakers opted for reducing unemployment at the expense of higher inflation1961636562646667688 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFEvidence for the Phillips Curv 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(2)Shifts in Phillips Curve:Role of Expectations9 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(2)Shifts in Phillips Curve:2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(A)The Vertical Long-Run Phillips Curve1968:Milton Friedman and Edmund Phelps argued that the tradeoff was temporary.Natural-rate hypothesis:the claim that unemployment eventually returns to its normal or“natural”rate,regardless of the inflation rateBased on the classical dichotomy and the vertical LRAS curve10 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(A)The Vertical Long-Run PhilThe Vertical Long-Run Phillips Curveu-rateinflationIn the long run,faster money growth only causes faster inflation.YPLRASAD1AD2Natural rate of outputNatural rate of unemploymentP1P2LRPClow infla-tionhigh infla-tion1111 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe Vertical Long-Run Phillips 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(B)Reconciling Theory and EvidenceEvidence(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 a measure of how much people expect the price level to change.12 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(B)Reconciling Theory and Evi 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(C)The Phillips Curve EquationShort run The Central Bank can reduce u-rate below the natural u-rate by making inflation greater than expected.(Note that b 0.)Long run Expectations catch up to reality(when expected inflation=actual inflation),u-rate goes back to natural u-rate whether inflation is high or low.Unemp.rateNatural rate of unemp.=bActual inflationExpected inflation 13 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(C)The Phillips Curve Equatio 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(D)How Expected Inflation Shifts the PCInitially,expected&actual inflation=3%,unemployment=natural rate(6%).Central Bank makes inflation 2%higher than expected,u-rate falls to 4%.In the long run,expected inflation increases to 5%,PC shifts upward,unemployment returns to its natural rate.u-rateinflationPC1LRPC6%3%PC24%5%ABC14 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(D)How Expected Inflation ShiNatural rate of unemployment=5%Expected inflation=2%In PC equation,b=0.5A.Plot the long-run Phillips curve.B.Find the u-rate for each of these values of actual inflation:0%,6%.Sketch the short-run PC.C.Suppose expected inflation rises to 4%.Repeat part B.D.Instead,suppose the natural rate falls to 4%.Draw the new long-run Phillips curve,then repeat part B.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 1 A numerical example1515 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFNatural rate of unemployment=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 1 Answers16LRPCAAn increase in expected inflation shifts PC to the right.PCDLRPCDPCBPCCA fall in the natural rate shifts both curves to the left.16 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFA C T I V E L E A R N I N G 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(E)The Breakdown of the Phillips CurveInflation rate(%per year)Unemployment rate(%)Early 1970s:unemployment increased,despite higher inflation.Friedman&Phelps explanation:expectations were catching up with reality.196163656264666768697071727317 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(E)The Breakdown of the Phill 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(3)Shifts in Phillips Curve:Role of Supply Shocks18 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(3)Shifts in Phillips Curve:2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.Another PC Shifter:Supply ShocksSupply shock:an event that directly alters firms costs and prices,shifting the AS and PC curves Example:large increase in oil prices 19 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFAnother PC Shifter:Supply S 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.How an Adverse Supply Shock Shifts the PCu-rateinflationSRAS shifts left,prices rise,output&employment fall.Inflation&u-rate both increase as the PC shifts upward.YPSRAS1ADPC1PC2ABSRAS2AY1P1Y2BP220 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFHow an Adverse Supply Shock Sh 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The 1970s Oil Price ShocksThe Fed(U.S.Central Bank)chose to accommodate the first shock in 1973 with faster money growth.Result:Higher expected inflation,which further shifted PC.1979:Oil prices surged again,worsening the Feds tradeoff.38.001/198132.501/198014.851/197910.111/1974$3.561/1973Oil price per barrel21 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe 1970s Oil Price ShocksThe 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The 1970s Oil Price ShocksInflation rate(%per year)Unemployment rate(%)Supply shocks&rising expected inflation worsened the PC tradeoff.197273747576777879808122 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe 1970s Oil Price ShocksInfl 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(4)The Cost of Reducing Inflation23 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(4)The Cost of Reducing Infla 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The Cost of Reducing InflationDisinflation:a reduction in the inflation rate To reduce inflation,the Fed(U.S.Central Bank)must slow the rate of money growth,which reduces aggregate demand.Short run:Output falls and unemployment rises.Long run:Output&unemployment return to their natural rates.24 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe Cost of Reducing Inflation 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(A)Disinflationary Monetary PolicyContractionary monetary policy moves economy from A to B.Over time,expected inflation falls,PC shifts downward.In the long run,point C:the natural rate of unemployment,&lower inflation.u-rateinflationLRPCPC1natural rate of unemploymentAPC2CB25 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(A)Disinflationary Monetary P 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(B)Sacrifice RatioDisinflation requires enduring a period of high unemployment and low output.Sacrifice ratio:percentage points of annual output lost(over the years)per 1 percentage point reduction in inflationTypical estimate of the sacrifice ratio:5To reduce inflation rate 1%,must sacrifice 5%of a years output.Can spread cost over time,e.g.To reduce inflation by 6%,can eithersacrifice 30%of GDP for one yearsacrifice 10%of GDP for three years26 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(B)Sacrifice RatioDisinflatio 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(C)Rational Expectations,Costless Disinflation?Rational expectations:a theory according to which people optimally use all the information they have,including information about government policies,when forecasting the future Early proponents:Robert Lucas,Thomas Sargent,Robert BarroImplied that disinflation could be much less costly27 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(C)Rational Expectations,Cos 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.Rational Expectations,Costless Disinflation?Suppose the Central Bank convinces everyone it is committed to reducing inflation.Then,expected inflation falls,the short-run PC shifts downward quickly.Result:Disinflations can cause less unemployment than the traditional sacrifice ratio predicts.In the extreme case,it could be close to zero,when people adjust inflation expectation immediately.28 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFRational Expectations,Costles 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(D)The Volcker DisinflationFed Chairman Paul VolckerAppointed in late 1979 under high inflation&unemploymentChanged Fed policy to disinflation1981-1984:Fiscal policy was expansionary,so Fed policy had to be very contractionary to reduce inflation.Success:Inflation fell from 10%to 4%,but at the cost of high unemployment29 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(D)The Volcker DisinflationFe 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The Volcker DisinflationInflation rate(%per year)Unemployment rate(%)Disinflation turned out to be very costlyu-rate near 10%in 1982-831979808182838485868730 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe Volcker DisinflationInflat 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(E)The Greenspan Era1986:Oil prices fell 50%.1989-90:Unemployment fell,inflation rose.Fed raised interest rates,caused a mild recession.1990s:Unemployment and inflation fell.2001:Negative demand shocks created the first recession in a decade.Policymakers responded with expansionary monetary and fiscal policy.Alan Greenspan Chair of FOMC,Aug 1987 Jan 200631 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(E)The Greenspan Era1986:Oi 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.The Greenspan EraInflation rate(%per year)Unemployment rate(%)Inflation and unemployment were low during most of Alan Greenspans years as Fed Chairman.19879092200094969806020532 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFThe Greenspan EraInflation rat 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.(F)Ben Bernankes challengesAggregate demand shocks:Subprime mortgage crisis,falling housing prices,widespread foreclosures,financial sector troubles.Aggregate supply shocks:Rising prices of food/agricultural commodities,e.g.,Corn per bushel:$2.10 in 2005-06,$5.76 in 5/2008Rising oil pricesOil per barrel:$35 in 2/2004,$134 in 6/2008From 6/2007 to 6/2008,unemployment rose from 4.6%to 5.5%CPI inflation rose from 2.6%to 4.9%33 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF(F)Ben Bernankes challengesA 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.CONCLUSIONThe theories in this chapter come from some of the greatest economists of the 20th century.They teach us that inflation and unemployment areunrelated in the long runnegatively related in the short runaffected by expectations,which play an important role in the economys adjustment from the short-run to the long run.34 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFCONCLUSIONThe theories in thisCHAPTER SUMMARYThe Phillips curve describes the short-run tradeoff between inflation and unemployment.In the long run,there is no tradeoff:inflation is determined by money growth,while unemployment equals its natural rate.Supply shocks and changes in expected inflation shift the short-run Phillips curve,making the tradeoff more or less favorable.3535 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFCHAPTER SUMMARYThe Phillips cuCHAPTER SUMMARYThe Central Bank can reduce inflation by contracting the money supply,which moves the economy along its short-run Phillips curve and raises unemployment.In the long run,though,expectations adjust and unemployment returns to its natural rate.Some economists argue that a credible commitment to reducing inflation can lower the costs of disinflation by inducing a rapid adjustment of expectations.3636 ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFFCHAPTER SUMMARYThe Central Ban