The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P.

1. The Phillips Curve

A. Origins of the Phillips Curve

 In 1958, economist A. W. Phillips published an article discussing the negative
correlation between inflation rates and unemployment rates in the UK.
 And then two years later, American economists Paul Samuelson and Robert Solow
showed a similar relationship between inflation and unemployment for the U.S.
 The belief was that high unemployment is related to low AD , and low AD
will [ push up / pull down ] price level. Likewise, low unemployment is related to
high AD , and high AD [ push up / pull down ] prices.

 Definition of Phillips curve: a curve Inflation Rate

(percent per year)
that shows the short-run
trade-off between inflation B
and unemployment. 6%

 Because policies (monetary or fiscal)

can affect AD. Samuelson and Solow
believed that the Phillips curve offered 2%
A
policymakers a menu of choices over
Phillips curve
these economic outcomes.
4% 7% Unemployment
Rate (percent)

B. Aggregate Demand (AD), Aggregate Supply (AS), and the Phillips Curve
 The Phillips curve shows the combinations of INFL and UNEM that arise in SR due to
shifts in AD curve.

 Example: In 2019, the price level (measured by the CPI) is 100. Two possible changes
in the economy for the year 2020 are: a low or high level of AD.
* If the economy experiences a low level of AD, we would be at a SR equilibrium like
point A. This point also corresponds with point A on the Phillips curve, with
[ high / low ] i-rate and [ high / low ] u-rate.
* If the economy experiences a high level of AD, we would be at a SR equilibrium like
point B. This point also corresponds with point B on the Phillips curve, with
[ high / low ] i-rate and [ high / low ] u-rate.

(a) The Model of AD and AS (b) The Phillips Curve

Price level i-rate
SRAS

106 b 6% B (High AD)

a
102 High AD
2% A (Low AD)
Phillips Curve
Low AD
15,000 16,000 Q of 4% 7% U-rate
u-rate is u-rate is Output
7% 4%
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The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 2

 Note that although there is no direct formula converting output to unemployment

rate, higher output generally means lower u-rate.

 Both monetary and fiscal policies shift the AD curve; therefore, these policies can
move the economy along the Phillips curve.

2. Shifts in the Phillips Curve: The Role of Expectations

A. The Long-Run Phillips Curve

 In 1968, economist Milton Friedman argued that monetary policy enables the trade-
off between UNEM and INFL only for a short period of time. At the same
time, economist Edmund Phelps wrote a paper suggesting the same thing.

 In the long run, monetary growth (or change in P) has no real effects on
output. Thus, we would not expect there to be a relationship between UNEM and
INFL. In other words, the LR Phillips curve must be vertical .

Price level i-rate

LRAS Phillips curve

P2 c i2 C

AD2
P1 a i1 A

AD1
Natural rate Q of Natural rate U-rate
of output Output of unemployment

 In fact, we have the vertical Phillips Curve because the Long-Run AS curve is also
vertical. That is, when an increase in AD would only result in higher prices (point a -->
c), this means the change of the inflation rate is irrelevant to does not change
the U-rate (point A --> C).

 And, when the economy is producing at the natural rate of output (defined by LRAS),
it is thought that the economy’s unemployment rate would be at its natural rate level
(defined by the LR Phillips Curve).

B. The role of expectation

 Price level expectations play an important role in the economy’s adjustment from
the SR to the LR.

 One variable that determines the position of SRAS (short-run supply schedule) is the
expected level of inflation . This is true because the expected price
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The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 3

level determines the setting of nominal wages & prices and also affects the
perceptions of relative prices that firms may have.

 In the short run, these expectations are somewhat fixed . Thus, when the Fed
increases the MS, AD increases along the existing upward sloping SRAS. So as output
grows ( u-rate falls ) and the price level rises ( i-rate rises ),
resulting in the SR trade-off between inflation and unemployment.

 Eventually, however, people will begin expecting a higher i-rate . As the

(sticky) nominal wages and prices are adjusted upward, and firms’ misperception
on the higher selling price of their products is corrected, firms cut down their
production to the original level (see Chapter 33). So the economy would return to the
normal, natural rate of LR output & u-rate alongside a higher
price level & i-rate. That is, both SRAS and SRPC curves would shift.

Price level i-rate

LRAS SRAS2 LRPC
SRAS1

112.5 c 5% B C

107.1 b

102 a 2% A SRPC’
AD2 (high expected inflation)

AD1 SRPC (low expected inflation)

YN Yhigh Y 3% Natural U = 6% U-rate

C. The Short-Run Phillips Curve (SRPC)

 To generalize, the actual u-rate is dependent on the natural u-rate, actual i-rate, and
expected i-rate. We have this Phillips Curve equation:

* U-rate = Natural U – a (actual i – expected i)

 Because in the SR, natural U, expected inflation are fixed, the U-rate
can be manipulated through actual inflation (which is achievable by
changes in MS or monetary policy).

 (The extent to which U responds to the unexpected change in inflation depends on

the coefficient “a”, which is related to the slope of SRAS – assumed constant in
our analysis.)

 Now, suppose that policymakers want to take advantage of the SR trade-off between
unemployment and inflation, it may lead to negative consequence:

* Suppose the economy is at point A and policymakers wish to lower the u-rate.
Expansionary monetary policy or fiscal policy is used to shift AD to the right. The
economy moves to point B, with a lower u-rate and a higher i-rate .

© 2020 by Sunny HA
The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 4

* Over time, people get used to this new level of inflation and raise their expectations
of inflation. This leads to an upward shift of SRAS and also the SR Phillips curve. The
economy ends up at point C, with a higher i-rate than at point A, and the u-rate
returns to normal .

D. “Natural-Rate Hypothesis”: proposed that unemployment eventually returns

to its normal, or natural rate, regardless of the rate of inflation.

 A good way to test its validity is through “natural experiment” – continual

observation of real economic outcomes for a long period.

 The figure on the left shows the unemployment and inflation rates from 1961 to 1968.
It is easy to see the inverse relationship between these two variables.

 However, the figure on the right shows that this simple inverse relationship began
to vanish during early 1970s.

 As the natural-rate hypothesis predicts, the u-rate returned to its natural rate
of around 6% given the upward revision on inflation expectation.

3. Shifts in the Phillips Curve: The Role of Supply Shocks

A. In 1974, OPEC increased the price of oil sharply. This increased the cost of producing
many goods and services and therefore resulted in an adverse supply shock .

 An adverse supply shock shifts the economy’s SRAS curve to the [ left / right ],
which results in lower equilibrium output ( Y ) and higher price level ( P ) or
stagflation .

 This mix of higher must on u-rate and higher i-rate present itself on a
new SR Phillips curve, which is formed [ left / right ] to the existing one.

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The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 5

(a) The Model of AD and AS (b) The Phillips Curve

Price Inflation 4. . . . giving
1. An adverse shift
level 3. . . . and raises Rate policymakers
in aggregate supply . . .
the price level . . . a less favorable
AS2 trade-off between
unemployment
Aggregate and inflation.
B
P2 supply, AS1
B
A
P1 A
2. . . . lowers output . . .

Aggregate PC2
demand Phillips curve, PC1
0 Y2 Y1 Quantity of output 0 Unemployment Rate

B. This supply shock would leave policymakers

with a less favorable SR trade-off between
unemployment and inflation.
 If they increase AD to fight unemployment,
they will raise INFL further.

 If they lower AD to fight inflation, they will

raise UNEM further.

C. The supply shock in 1974 had led the U.S. to

enter into a period of stagflation until early
1980s.

4. The Cost of Reducing Inflation

A. To reduce the inflation rate, the Fed must follow contractionary monetary policy.

 As AD falls, P and Y (according to the AD-AS model)

 The economy moves from point A along the SR Phillips curve to point B, which has
a lower i-rate but a higher u-rate .

LRPC

5% A

C B
2% SRPC
(high expected inflation)

SRPC (low expected inflation)

Natural U 9% U-rate
= 6%

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The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 6

 Over time, as people revise their inflation expectations [ upward / downward ], the u-
rate will return to its natural rate while i-rate stays at the same level, as the natural-
rate hypothesis predicts. That is, a shift of Phillips Curve to the [ left / right ] and
economy may end up at point C.

 This implies that, to reduce inflation, the economy must suffer through a period of
high unemployment and low output.

 A “sacrifice ratio” of five is typically estimated, which means that, for each
percentage point inflation is decreased, output would fall by 5%.

B. Rational Expectations and the Possibility of Costless Disinflation

 If people are rational, there is a possibility to achieve lower inflation (i.e.

disinflation ) at no cost (i.e. without increasing unemployment ).

 This conjecture is based on the theory of rational expectations, which states that
people optimally use all the information , including
government policies ,when forecasting the future.

 It is therefore believed that, when government policies change or is perceived to

change, people alter their expectations about inflation accordingly and quickly.

* If the government makes a credible commitment to a policy of low inflation,

people would be rational enough to lower their expectations of inflation
immediately.

* This implies that the SR Phillips curve would shift quickly without
any extended period of high unemployment. (That is, jump from point A to C
bypassing point B )

C. The Volcker Disinflation – a proof of rational-expectations theory?

 The possibility of costless disinflation

has been explored through the annual
data from 1979 to 1987 when Paul
Volcker was the chairman of the Fed.

 However, the reduction in inflation ?

during this period came at the cost of
high unemployment in 1982 and 1983.
In fact, the United States experienced
its deepest recession since the Great
Depression.

 The unemployment did improve after recession, probably due to the revision of
inflation expectations to the low side.

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The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 7

 Some economists offered this as proof that the idea of a costless disinflation
suggested by rational-expectations theorists is not possible . However,
there are two reasons why we still hold on the rational-expectations theory:

* The cost (in terms of lost output) of the Volcker disinflation was not as large
as many economists had predicted.

* While Volcker promised that he would fight inflation, many people did
not believe him . Few people thought that inflation would fall as
quickly as it did; this likely prevented the SR Phillips curve from shifting quickly.

5. The Greenspan Era till now

A. The Greenspan Era

 This figure shows annual data from 1984 to 2005. During most of this period, Alan
Greenspan was chairman of the Federal Reserve and fluctuations in inflation and
unemployment were relatively small .

 There was economic recession from 2001 to 2003 due to the “9-11”
terrorist attack, corporate accounting scandals and stock market crash that
depressed AD.

 But a combination of expansionary monetary and fiscal policies helped end

the downturn, and by early 2005, the unemployment rate was close to the estimated
natural rate.

A
Feb 2020 B

B. The Phillips Curve during the Financial Crisis 2008-2009

 In his first couple of years as Fed chairman, Bernanke faced some significant economic
challenges, which stemmed from the housing and financial markets.

 The resulting financial crisis led to a large drop in AD and high rates of
unemployment.

 As the unemployment rate rose, the i-rate fell . The SR tradeoff between
INFL and UNEM of the Phillips Curve happened again.
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The Short-Run Trade-off between Inflation & Unemployment: Chapter 35 P. 8

C. From 2010 to 2015 (and beyond)

 Policymakers used expansionary monetary and fiscal policy to lower unemployment

and, by 2015, the unemployment rate had returned to its natural level.

 Inflation had been stabilized at below 2% after much of credible commitment by the
Fed to maintain inflation at such level.

 As of February 2020, the inflation rate in the US was 2.3%, and unemployment rate
was 3.5%, which has been far better than its natural level.

© 2020 by Sunny HA