Chapter 35: The Short-Run Trade-Off between Inflation and Unemployment

35-1. The Phillips Curve

- Phillips curve: a curve that shows the short-run trade-off between inflation and
unemployment
1. The Origin of the Phillips Curve
- In 1958, economist Alban William Phillips discovered an inverse relationship
between unemployment and wage inflation in the UK.
- In 1960, Paul Samuelson and Robert Solow extended this idea to the U.S. economy,
linking low unemployment with high aggregate demand, which pushes wages and
prices up.
- They later named this inverse relationship the Phillips Curve (PC).
- Policymakers: Monetary and fiscal policy
+ To influence aggregate demand
+ Trade-off: High unemployment & low inflation or low unemployment and
high inflation

2. Aggregate Demand, Aggregate Supply, and the Phillips Curve

Figure: How the Phillips Curve Is Related to the Model of Aggregate Demand
and Aggregate Supply
 Impact of AD Changes:

- Higher AD → More output, higher prices, lower unemployment, higher inflation.

- Lower AD → Less output, lower prices, higher unemployment, lower inflation.

35-2 Shifts in the Phillips Curve: The Role of Expectations

35-2a The Long-Run Phillips Curve

- Classical Economic Theory: Money supply growth primarily determines inflation but
does not affect real economic variables like output and employment.
- Limits of Monetary Policy: The Federal Reserve can control nominal variables (such
as inflation and money supply growth) but cannot influence real variables (such as
unemployment and real income) in the long run.
- Vertical Long-Run Phillips Curve: Unemployment remains at its natural rate
regardless of inflation, illustrating that monetary policy does not affect employment
over time.
- Monetary Neutrality: The vertical long-run aggregate-supply curve and the vertical
long-run Phillips curve both imply that monetary policy influences nominal variables
(the price level and the inflation rate) but not real variables (output and
unemployment). In the long run, regardless of the monetary policy pursued by the
Fed, output is at its natural level and unemployment is at its natural rate.

35-2d The Short-Run Phillips Curve

Unemployment rate = Natural rate of unemployment - a (Actual inflation - Expected
inflation)

- In the short run, expected inflation is given, so higher actual inflation is associated
with lower unemployment. (The variable a is a parameter that measures how much
unemployment responds to unexpected inflation.) In the long run, people come to
expect whatever inflation the Fed produces, so actual inflation equals expected
inflation, and unemployment is at its natural rate
- Unstable Short-Run Phillips Curve: There is no fixed trade-off between inflation
and unemployment because the short-run Phillips curve shifts when inflation
expectations change.
- Policy Limitations: Policymakers cannot use the Phillips curve as a stable menu of
choices. Attempts to lower unemployment through higher inflation work only
temporarily.
- Adjustment of Expectations: As people adapt to higher inflation, they adjust wages
and prices accordingly, shifting the short-run Phillips curve upward.
- Long-Run Consequences: Expanding aggregate demand leads only to higher
inflation without reducing unemployment in the long run, reinforcing the conclusion
that monetary policy cannot sustainably lower unemployment.

35-2e The Natural Experiment for the Natural-Rate Hypothesis

 1. Prediction by Friedman and Phelps (1968)

○ Policies that increase inflation to reduce unemployment will only have

temporary effects.
○ Unemployment will eventually return to its natural rate, regardless of the
inflation rate.
○ -> natural-rate hypothesis.
2. Context before 1968

○ Data from 1961-1968 showed a negative relationship between inflation and

unemployment, consistent with the Phillips curve.
○ Many economists believed policymakers could exploit this relationship to
control unemployment.
3. Expansionary Policies in the Late 1960s - Early 1970s

○ Fiscal policy: Government spending increased significantly due to the

Vietnam War.
○ Monetary policy: The money supply grew rapidly (13% per year from 1970-
1972, compared to 7% per year in the early 1960s).
○ Consequences: Inflation remained high (5-6% compared to 1-2% previously),
but unemployment did not stay low in the long run.
4. Validation of Friedman & Phelps’ Hypothesis

○ By 1970, the relationship between inflation and unemployment began to break

down.
○ As inflation expectations caught up with reality, unemployment returned to the
5-6% range, similar to the early 1960s.
○ By 1973, policymakers realized that there was no long-term trade-off between
inflation and unemployment.

35. 3. Shifts in the Phillips Curve: The Role of Expectations

1. The Long-Run Phillips Curve

- Classical Economic Theory: Money supply growth primarily determines inflation but
does not affect real economic variables like output and employment.
- Limits of Monetary Policy: The Federal Reserve can control nominal variables (such
as inflation and money supply growth) but cannot influence real variables (such as
unemployment and real income) in the long run.
- Vertical Long-Run Phillips Curve: Unemployment remains at its natural rate
regardless of inflation, illustrating that monetary policy does not affect employment
over time.
- Monetary Neutrality: The vertical long-run aggregate-supply curve and the vertical
long-run Phillips curve both imply that monetary policy influences nominal variables
(the price level and the inflation rate) but not real variables (output and
unemployment). In the long run, regardless of the monetary policy pursued by the
Fed, output is at its natural level and unemployment is at its natural rate.
2. The Short-Run Phillips Curve
a: a parameter that measures how much unemployment responds to unexpected inflation

- In the short run, expected inflation is given, so higher actual inflation is associated
with lower unemployment.
- In the long run, people come to expect whatever inflation the Fed produces, so actual
inflation equals expected inflation, and unemployment is at its natural rate
- Unstable Short-Run Phillips Curve: no fixed trade-off between inflation and
unemployment (the short-run Phillips curve shifts when inflation expectations
change).
- Policy Limitations: Policymakers cannot use the Phillips curve as a stable menu of
choices. Attempts to lower unemployment through higher inflation work only
temporarily.
- A supply shock raises production costs, reducing output while increasing prices.
- Example: The 1974 OPEC oil embargo led to soaring oil prices, reducing supply and
causing stagflation—a combination of rising inflation and unemployment.
3. How supply shocks—such as the 1970s oil crisis—can cause shifts in the Phillips
curve by affecting aggregate supply.

3.1 Supply shocks and stagflation

- A supply shock raises production costs, reducing output while increasing prices.
- Example: The 1974 OPEC oil embargo led to soaring oil prices, reducing supply and
causing stagflation—a combination of rising inflation and unemployment.

3.2 Impact on the Phillips Curve

- The short-run Phillips curve shifts rightward, worsening the trade-off between
inflation and unemployment.
- Policymakers face a dilemma:
+ Fighting inflation (by reducing demand) worsens unemployment.
+ Fighting unemployment (by stimulating demand) fuels inflation.
4. U.S. Policy Response & Long-Term Effects
- The Federal Reserve expanded the money supply to counteract economic slowdowns,
leading to higher expected inflation.
- By 1980, inflation exceeded 9%, and unemployment reached 7%, deepening
economic troubles.
- Public dissatisfaction with the economy contributed to President Jimmy Carter’s
defeat in the 1980 election.

35.4. The cost of inflation

35.4a. Sacrifice Ratio

To reduce inflation, the Fed must implement contractionary monetary policy. Research
estimates the sacrifice ratio, which measures the economic cost of lowering inflation.
 - A typical estimate is 5, meaning a 1% reduction in inflation leads to a 5% loss in
annual output during the transition.
- Some economists argue the sacrifice ratio could be lower, based on the rational
expectations theory.
- In an extreme case, if the government credibly commits to low inflation, people may
immediately adjust their expectations, reducing inflation without high unemployment
or output loss.
- Rational Expectations “individuals utilize all available information, including
government policies, when making economic forecasts.”

Impact on Inflation and Unemployment

- Expected inflation is a crucial factor in the short-run trade-off between inflation and
unemployment. When economic policies change, people adjust their expectations
accordingly, influencing both inflation and unemployment.

Critique of the Sacrifice Ratio

- Traditional estimates of the sacrifice ratio—the economic cost of reducing inflation—

are unreliable because they fail to account for the impact of policy changes on
inflation expectations.

35.4c Rational Expectations and Costless Disinflation

 1. Introduction to Rational Expectations
○ Economists like Robert Lucas, Thomas Sargent, and Robert Barro introduced
the rational expectations theory.
○ This theory suggests that people use all available information, including
government policies, when predicting the future.
2. Impact on Inflation and Unemployment
○ Expected inflation plays a key role in the short-run trade-off between inflation
and unemployment.
○ When policies change, people adjust their expectations, influencing inflation
and unemployment dynamics.
3. Critique of the Sacrifice Ratio
○ Traditional estimates of the sacrifice ratio (the cost of reducing inflation) are
unreliable because they ignore the effect of policy changes on expectations.
4. Sargent’s View on Inflation Control
○ Inflation continues because people expect it based on government policies.
○ If the government commits credibly to low inflation, expectations will adjust,
making inflation control less costly.
5. Key Conclusion
○ Disinflation requires a strong and credible policy shift.
○ In the best-case scenario, the economy could achieve low inflation without
high unemployment or output loss.

1. The Phillips curve started as an observed _________ correlation between the inflation
rate and the _________.
a. positive; nominal interest rate
b. positive; unemployment rate
c. negative; nominal interest rate
d. negative; unemployment rate

2. When the Federal Reserve increases the money supply and expands aggregate demand,
it moves the economy along the Phillips curve to a point with _________ inflation and
_________ unemployment.
a. higher; higher
b. higher; lower
c. lower; higher
d. lower; lower

3. The position of the long-run Phillips curve and the long-run aggregate supply curve both
depend on

A. the natural rate of unemployment and monetary growth

B. the natural rate of unemployment, but not monetary growth

C. monetary growth, but not the natural rate of unemployment.

D. neither monetary growth nor the natural rate of unemployment.

4. If the long-run Phillips curve shifts to the left, for any given rate of money growth and

inflation the economy will have

A. higher unemployment and lower output.

D. lower unemployment and higher output.

C. lower unemployment and lower output.

B. higher unemployment and higher output

5. Which of the following would not be associated with a favorable supply shock?

A. the short-run Phillips curve shifts left

B. unemployment falls

C. the price level rises

D. output rises

6. Faced with an adverse supply shock, policymakers can increase

A. aggregate demand, which increases prices and output

B. aggregate demand, which decreases prices and increases output

C. aggregate supply, which increases prices and output

D. aggregate supply, which decreases prices and increases output