Unemployment

& Inflation

Wong Wei Kang

Do not circulate without permission
 The Big Picture
Goods Mkt
Equil. Expectations-aug.
Sd=Id IS IS-LM Phillips Curve
Ch 4 curve model
Ch 9
Asset Mkt LM Explanation
Equil. curve of short-run
L(Y,i)=M/P fluctuations
Agg.
Ch 7
demand
curve Business
Labor Cycle
FE Agg. Theories
Mkt
line supply
Equil. Ch 10-11
curve
Ch 3

2
 Outline
• Unemployment & Inflation: Is There a Trade-Off?
• Expectations-Augmented Phillips Curve
• Macroeconomic Policy and the Phillips Curve
• The Natural Rate Hypothesis
• Alternative Hypothesis: Hysteresis

3
 Inflation vs. Unemployment
• Is there an inverse relationship between inflation and
unemployment?
– If yes, then to reduce inflation, the economy must tolerate
higher unemployment. To reduce unemployment, the
economy must accept higher inflation
• A. W. Phillips – Phillips curve
– Negative relationship between nominal wage growth
(inflation) and unemployment
– E.g., the U.S. economy expanded throughout most of the
1960s, with unemployment falling and inflation rising
steadily
4
Figure 12.1 The Phillips curve in the U.S. during the 1960s

5
 Inflation vs. Unemployment
• If true, then Phillips curve offers policymakers a
“menu” of combinations of inflation and
unemployment from which they could choose
• But the relationship fell apart in the following three
decades
– The 1970s were a particularly bad period, with both high
inflation and high unemployment, inconsistent with the
Phillips curve
• Oil Shocks → Stagflation
– High inflation and high unemployment
6
Fig M14.3 Inflation and unemployment in the U.S., 1960-2011

7
 Inflation vs. Unemployment
• Milton Friedman & Edmund Phelps
– No stable negative relationship between inflation and
unemployment
– Their prediction came before the relationship actually
broke down in the early 1970s
• Instead, negative relationship between unanticipated
inflation and cyclical unemployment
– They are right! The triumph of economic theory
– Cyclical unemployment = actual unemployment -
natural unemployment
8
Figure 12.2 Inflation and unemployment in the U.S.

9
Figure 12.7 The expectations-augmented Phillips curve in the U.S.

10
Expectations-Augmented Phillips Curve
• Illustrate using the misperceptions theory
• Figure 12.3: Anticipated increase in money supply
– Assume that the money supply has been growing at 10%
per year for many years and is expected to continue to grow
at this rate indefinitely
– AD shifts up and SRAS shifts up, with no misperceptions
• Result: P rises, Y unchanged
– Inflation rises with no change in unemployment

11
Figure 12.3 Ongoing inflation in the extended
classical model
Ms has been SRAS equation: Y = Y + b(P − P e )
growing at 10% per SRAS2
P LRAS
year for many years
and is expected to SRAS1
continue to grow at
this rate indefinitely 110

AD2
Both AD and SRAS 100
shift up by 10% per AD1
year Y
Y
12
 Expectations-Augmented Phillips Curve
• Figure 12.4: Unanticipated increase in money supply
– Against this backdrop of 10% monetary growth and 10%
inflation, suppose now that the money supply grows by 20%
rather than by the expected 10%
– AD expected to shift up to AD2,old (money supply expected to
rise 10%), but unexpectedly money supply rises 20%, so AD
shifts further up to AD2,new
– SRAS shifts up based on expected 10% rise in money supply
• Result: P rises and Y rises as misperceptions occur
– So higher inflation occurs with lower unemployment
– Long run: P rises further, Y declines to full-employment level
13
 Figure 12.4 Unanticipated inflation in the
extended classical model
Against a backdrop of SRAS equation: Y = Y + b(P − P e )
10% monetary growth
P LRAS SRAS2
and 10% inflation,
AD expected to shift SRAS1
up to AD2, old 115
110
Instead, Ms grows by AD2, new
20% rather than by AD2, old
100
the expected 10%, so
AD actually shifts AD1
further up to AD2, new Y
Y Y2
14
 Summary
• Phillips curve
– Negative empirical relationship between
unemployment and inflation
• Expectations-augmented Phillips curve
– Negative relationship between cyclical
unemployment and unanticipated inflation
• Unanticipated inflation = – e

• Cyclical Unemployment = u – u
e
π = π − h(u − u)
• When e, u u
15
Expectations-Augmented Phillips
Curve: Three Scenarios
π = π e − h(u − u )
e
π
!" # = −h (u
−π !"#− u )
Unanticipated Cyclical
Inflation Unemployment

Scenario 1: π = π e ⇔ u = u
e
Scenario 2: π > π ⇔ u < u
π − π e > 0 ⇔ −h(u − u ) > 0 ⇔ u − u < 0
e
Scenario 3: π < π ⇔ u > u
π − π e < 0 ⇔ −h(u − u ) < 0 ⇔ u − u > 0
16
 Natural Rate of Unemployment
• Natural unemployment ( u ) = unemployment when
output and employment are at full-employment
levels (only frictional and structural unemployment)
• Cyclical unemployment (u - u ) = difference between
actual unemployment (u) and natural unemployment u
• A negative relationship between inflation and
unemployment holds as long as expected inflation
and the natural unemployment rate are approximately
constant
17
 Graphing the Phillips curve
In the short p
π = π e − h(u − u )
run, policymakers
face a tradeoff
between p and u. h
1 The short-run
πe Phillips curve

u
u

18
 Shift in the Phillips Curve
• The expected inflation rate on a Phillips curve =
the inflation rate at the point where the actual
unemployment rate equals the natural rate
• Phillips curve shifts up and to the right
• ↑ expected inflation rate pe
• Figure 12.5
• The horizontal axis is the actual unemployment rate, the
vertical axis is the actual inflation rate
• ↑ natural unemployment rate u
• Figure 12.6
19
 Figure 12.5 The shifting Phillips curve:
an increase in expected inflation
People adjust p
their expectations π − π e = − h(u − u)
over time,
so the tradeoff π 2e
only holds in the
π 1e
short run

↑pe → SR Phillips
curve shifts up u
u

20
 New Classical Theory
The Lucas Critique
• To forecast the effects of a new set of policies, economists used to
assume that historical relationships between macroeconomic
variables will continue to hold after the new policies are in place
• Lucas objected to this assumption -- The Lucas critique: new
policies (particularly policies that haven’t been tried before) may
change the economic “rules” and thus affect economic behavior. So
we cannot safely assume that historical relationships between
variables will hold when policies change
• To predict accurately the effects of new policies, we need economic
theory to help us understand how economic behavior will change
under the new policies

21
 New Classical Theory
The Lucas Critique
• A good example of the Lucas critique in action is the
shifting short-run Phillips curve
• Historically, there seemed to be a stable tradeoff
between inflation and unemployment
• But when policymakers try to permanently reduce
unemployment by increasing inflation, this historical
relationship between inflation and unemployment
broke down because the public’s inflation expectations
will rise due to the policy change, causing the short-run
Phillips curve to shift
22
Figure 12.6 The shifting Phillips curve: an
increase in the natural unemployment rate
p
The natural rate π − π e = − h(u − u)
of unemployment
also changes over
time
π 1e
↑ u → SR
Phillips curve
shifts to the right
u
u1 u2

23
 Adverse Supply Shocks
• Two effects, both of which shift the Phillips
curve up and to the right
– It causes a burst of inflation → people expect
higher inflation
– It increases the natural unemployment rate
– ↑ mismatch between workers and jobs as the
energy-intensive industries contract

24
 Unemployment vs. Inflation
in the Long Run
• Money is neutral in the long run
– Changes in the growth rate of money → changes in
the inflation rate (growth rate of prices), with no real
effects in the long run
– In the long run, prices and wages are flexible
– Cannot systematically fool people because they will
eventually learn
• Long run Phillips curve is a vertical line at the natural
rate of unemployment (Figure 12.8)
25
Figure 12.8 The long-run Phillips curve

26
Figure 12.9 Actual and natural unemployment rates in the U.S.

27
 The Natural Rate Hypothesis
• Changes in aggregate demand affect output
and employment only in the short run.
• In the long run, the economy returns to the
levels of output, employment, and
unemployment described by the classical
model

28
Alternative Hypothesis: Hysteresis
• History has long lasting influence on variables such as
the natural rate of unemployment
• Negative shocks may increase the natural rate, so
economy may not fully recover
– The skills of cyclically unemployed workers deteriorate while
unemployed
– Government regulation that makes firing difficult
• Firms won’t hire unless they are confident that they won’t have to
reduce their work forces for a long time
– Cyclically unemployed workers may lose their influence on
wage-setting; insiders (employed workers) versus cyclically
unemployed “outsiders”
29
 Unemployment Rates in Continental Europe Versus U.S.
Unemployment rate in the 4 largest continental European countries has gone
from being much lower than the U.S. unemployment rate to being much higher.

30
 Figure 7.05M The Rise in Unemployment Rates in Europe
The persistence of high unemployment suggests that the natural
unemployment rate also increased – hysteresis

31
 Reducing the Natural Rate
• ↓ mismatch of workers and jobs
– Government support for job training and worker
relocation
– Increased labor market flexibility
– Unemployment insurance reform
• The hysteresis idea
– If monetary and fiscal policy are used aggressively to
keep unemployment as low as possible, then the
natural rate will eventually fall
– But inflation may rise. Controversial.
32
I want you to also remember that the best predictor of how good an
economist you are, or will be, is not some grade, but your commitment to
the subject matter. There are billions of poor people out there. There are also
some rich people who have economic and social problems so there is very
good reason to make such a commitment.
George Akerlof
 ―W―

You have to work very hard to make

everything seem effortless.

If a class does not challenge you in some

ways, it probably has little value added.