CHAPTER 35 The ShortRun Tradeoff Between Inflation and

CHAPTER 35 The Short-Run Trade-off Between Inflation and Unemployment Economics N. Gregory Mankiw PRINCIPLES OF N. Gregory Mankiw Premium Power. Point Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved

In 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 1990 s? 1

Introduction In 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. THE SHORT-RUN TRADE-OFF 2

Classical Economics—A Recap The previous chapters are based on the ideas of classical economics, especially: The Classical Dichotomy, the separation of variables into two groups: Real – quantities, relative prices Nominal – measured in terms of money The neutrality of money: Changes in the money supply affect nominal but not real variables. AGGREGATE DEMAND AGGREGATE SUPPLY 3

Classical Economics—A Recap Most economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). To study the short run, we use a new model. AGGREGATE DEMAND AGGREGATE SUPPLY 4

Non-Neutrality of Money • Money has no real effect in the long run. • Money has real effects in the short run. • Monetary shock could be a source of economic fluctuation • Monetary policy could stabilize economic fluctuation • Three theories of the non-neutrality • All based on some market imperfection

1. The Sticky-Wage Theory Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. AGGREGATE DEMAND AGGREGATE SUPPLY 6

1. The Sticky-Wage Theory If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y. AGGREGATE DEMAND AGGREGATE SUPPLY 7

2. The Sticky-Price Theory Imperfection: Many prices are sticky in the short run. Due to menu costs, the costs of adjusting prices. Examples: cost of printing new menus, the time required to change price tags Firms set sticky prices in advance based on PE. AGGREGATE DEMAND AGGREGATE SUPPLY 8

2. The Sticky-Price Theory Suppose the Fed increases the money supply unexpectedly. Nominal interest rate goes down. People are inclined to consume more today but less tomorrow. Prices are expected to rise today but fall tomorrow. In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Tomorrow’s inflation rate is expected to fall slowly, less than the fall in nominal interest rate. Thus, real interest rate falls. This boosts consumption today. Thus, GDP rises in the short run. AGGREGATE DEMAND AGGREGATE SUPPLY 9

THE SHORT-RUN TRADE-OFF 10

The Phillips Curve Phillips 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. ” THE SHORT-RUN TRADE-OFF 16

The Phillips Curve: A Policy Menu? Since fiscal and mon policy affect agg demand, the PC appeared to offer policymakers a menu of choices: low unemployment with high inflation low inflation with high unemployment anything in between 1960 s: U. S. data supported the Phillips curve. Many believed the PC was stable and reliable. THE SHORT-RUN TRADE-OFF 17

Figure 1 The Phillips Curve Inflation Rate (percent per year) B 6 A 2 Phillips curve 0 4 7 Unemployment Rate (percent) Copyright © 2004 South-Western

Evidence for the Phillips Curve? Inflation rate (% per year) During the 1960 s, U. S. policymakers opted for reducing unemployment at the expense of higher inflation 68 67 66 65 64 THE SHORT-RUN TRADE-OFF 62 63 1961 Unemployment rate (%) 19

Figure 3 The Long-Run Phillips Curve Inflation Rate 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases. . . High inflation Low inflation 0 Long-run Phillips curve B A Natural rate of unemployment 2. . but unemployment remains at its natural rate in the long run. Unemployment Rate Copyright © 2004 South-Western

The Vertical Long-Run Phillips Curve 1968: 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 rate Based on the classical dichotomy. THE SHORT-RUN TRADE-OFF 21

Reconciling Theory and Evidence (from ’ 60 s): 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. THE SHORT-RUN TRADE-OFF 22

The Phillips Curve Equation Unemp. = rate Natural Actual Expected – rate of – a inflation unemp. Short run Fed can reduce u-rate below the natural u-rate by making inflation greater than expected. Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low. THE SHORT-RUN TRADE-OFF 23

How Expected Inflation Shifts the PC Initially, expected & actual inflation = 3%, unemployment = natural rate (6%). Fed 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. THE SHORT-RUN TRADE-OFF inflation 5% LRPC B C A 3% PC 2 PC 1 4% 6% u-rate 24

ACTIVE LEARNING 1 A numerical example Natural rate of unemployment = 5% Expected inflation = 2% In PC equation, a = 0. 5 A. 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. 25

ACTIVE LEARNING Answers An increase in expected inflation shifts PC to the right. A fall in the natural rate shifts both curves to the left. 1 LRPCD PCB LRPCA PCD PCC 26

The Breakdown of the Phillips Curve Inflation rate (% per year) Early 1970 s: unemployment increased, Friedman & despite higher inflation. Phelps’ explanation: 73 expectations 71 69 70 were catching 68 72 up with reality. 66 67 65 64 THE SHORT-RUN TRADE-OFF 62 63 1961 Unemployment rate (%) 27

Another PC Shifter: Supply Shocks Supply shock: an event that directly alters firms’ costs and prices, shifting the AS and PC curves Example: large increase in oil prices THE SHORT-RUN TRADE-OFF 28

• The short-run Phillips curve also shifts because of shocks to aggregate supply: where s is a supply shock or a cost-push shock.

• A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. • This shifts the economy’s aggregate supply curve and as a result, the Phillips curve.

• Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. • An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

The 1970 s Oil Price Shocks Oil price per barrel 1/1973 $ 3. 56 1/1974 10. 11 1/1979 14. 85 1/1980 32. 50 1/1981 38. 00 The Fed 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 Fed’s tradeoff. THE SHORT-RUN TRADE-OFF 32

The 1970 s Oil Price Shocks Inflation rate (% per year) 81 75 74 79 78 77 73 76 1972 THE SHORT-RUN TRADE-OFF 80 Supply shocks & rising expected inflation worsened the PC tradeoff. Unemployment rate (%) 33

The Cost of Reducing Inflation Disinflation: a reduction in the inflation rate To reduce inflation, Fed must slow the rate of money growth, which reduces agg demand. Short run: Output falls and unemployment rises. Long run: Output & unemployment return to their natural rates. THE SHORT-RUN TRADE-OFF 34

Disinflationary Monetary Policy Contractionary monetary policy moves economy inflation from A to B. LRPC Over time, expected inflation falls, PC shifts downward. In the long run, point C: the natural rate of unemployment, lower inflation. THE SHORT-RUN TRADE-OFF A B C PC 1 PC 2 u-rate natural rate of unemployment 35

The Cost of Reducing Inflation Disinflation requires enduring a period of high unemployment and low output. Sacrifice ratio: percentage points of annual output lost per 1 percentage point reduction in inflation Typical estimate of the sacrifice ratio: 5 To reduce inflation rate 1%, must sacrifice 5% of a year’s output. Can spread cost over time, e. g. To reduce inflation by 6%, can either sacrifice 30% of GDP for one year sacrifice 10% of GDP for three years THE SHORT-RUN TRADE-OFF 36

Rational Expectations, Costless Disinflation? Rational expectations: a theory according to which people optimally use all the information they have, including info about govt policies, when forecasting the future Early proponents: Robert Lucas, Thomas Sargent, Robert Barro Implied that disinflation could be much less costly… THE SHORT-RUN TRADE-OFF 37

Rational Expectations, Costless Disinflation? Suppose the Fed convinces everyone it is committed to reducing inflation. Then, expected inflation falls, the short-run PC shifts downward. Result: Disinflations can cause less unemployment than the traditional sacrifice ratio predicts. THE SHORT-RUN TRADE-OFF 38

The Volcker Disinflation Fed Chairman Paul Volcker Appointed in late 1979 under high inflation & unemployment Changed Fed policy to disinflation 1981 -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 unemployment… THE SHORT-RUN TRADE-OFF 39

The Volcker Disinflation Inflation rate (% per year) Disinflation turned out to be very costly u-rate near 10% in 1982 -83 81 80 1979 82 84 85 87 83 86 THE SHORT-RUN TRADE-OFF Unemployment rate (%) 40

The Greenspan Era 1986: Oil prices fell 50%. 1989 -90: Unemployment fell, inflation rose. Fed raised interest rates, caused a mild recession. 1990 s: Unemployment and inflation fell. 2001: Negative demand shocks Alan Greenspan Chair of FOMC, Aug 1987 – Jan 2006 created the first recession in a decade. Policymakers responded with expansionary monetary and fiscal policy. THE SHORT-RUN TRADE-OFF 41

The Greenspan Era Inflation rate (% per year) Inflation and unemployment were low during most of Alan Greenspan’s years as Fed Chairman. 90 05 1987 06 2000 98 THE SHORT-RUN TRADE-OFF 92 96 02 94 Unemployment rate (%) 42

Ben Bernanke’s challenges Aggregate 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 5/2008 Rising oil prices Oil per barrel: $35 in 2/2004, $134 in 6/2008 From 6/2007 to 6/2008, unemployment rose from 4. 6% to 5. 5% CPI inflation rose from 2. 6% to 4. 9% THE SHORT-RUN TRADE-OFF 43

CONCLUSION The theories in this chapter come from some of the greatest economists of the 20 th century. They teach us that inflation and unemployment are unrelated in the long run negatively related in the short run affected by expectations, which play an important role in the economy’s adjustment from the short-run to the long run. THE SHORT-RUN TRADE-OFF 44

CHAPTER SUMMARY The 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. 45

CHAPTER SUMMARY The Fed 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. 46