CHAPTER17Inflation, Unemploymentand Federal Reserve PolicyChapterOutlineandLearningObjectives17.1 TheDiscoveryoftheShortRunTrade-offbetweenUnemployment and Inflation17.2 TheShort-Run and LongRunPhillips Curves17.3ExpectationsoftheInflationRateand Monetary Policy17.4 FederalReservePolicyfromthe1970stothePresent1of36
1 of 36 Chapter Outline and Learning Objectives 17.1 The Discovery of the ShortRun Trade-off between Unemployment and Inflation 17.2 The Short-Run and LongRun Phillips Curves 17.3 Expectations of the Inflation Rate and Monetary Policy 17.4 Federal Reserve Policy from the 1970s to the Present CHAPTER 17 CHAPTER Inflation, Unemployment, and Federal Reserve Policy
TheDiscoveryoftheShort-RunTrade-offbetweenUnemploymentandInflation17.1LEARNINGOBJECTIVEDescribethePhillips curveand thenature of theshort-runtrade-offbetweenunemploymentandinflation.@2015PearsonEducafion,lnc2of36
LEARNING OBJECTIVE © 2015 Pearson Education, Inc. 2 of 36 The Discovery of the Short-Run Trade-off between Unemployment and Inflation 17.1 Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation
Unemploymentand InflationInflationThe two greatrate(percentmacroeconomicproblemsper year)that the Fed deals with (inthe short run) are4%unemployment andinflation.But these two are related2in an important way:higherlevels of inflationare associated withlower06Unemployment5%levels of unemployment,rate(percent)Figure 17.1The Phillips curveand vice versa.ThisrelationshipisknownasthePhillipscurve,aftereconomistA.W. Phillips, the first to identify this relationshipPhillips curve:Acurve showing the short-runrelationship betweenthe unemployment rate and the inflation rate.2015PearsonEducation,Inc.3of36
© 2015 Pearson Education, Inc. 3 of 36 Unemployment and Inflation The two great macroeconomic problems that the Fed deals with (in the short run) are unemployment and inflation. But these two are related in an important way: higher levels of inflation are associated with lower levels of unemployment, and vice versa. This relationship is known as the Phillips curve, after economist A.W. Phillips, the first to identify this relationship. Phillips curve: A curve showing the short-run relationship between the unemployment rate and the inflation rate. Figure 17.1 The Phillips curve
WhyDoesthePhillips CurveExist?1.if thereisonlyaweakincreaseinAD,thepricelevelandrealGDPPricelevelInflationincreaselessthan.(GDPdeflator,rate2009=100)(percentShort-runTheeconomyin2016peryear)aggregateifthereisstrongsupply,SRASgrowthinAD.2...ifthere isa strong114.4increaseinAD.4%112.2Theeconomyin2016,110.0ifthereisweakgrowthinAD,AD2016 (strongincreaseindemand)B2AD2016 (weakAD2015increase indemand)Phillipscurve17.6RealGDP060$17.017.35%Unemployment(trillions ofrate (percent)2009dollars)(a)Theeffectsofanincreaseinaggregatedemand(b)ThePhillips curveIn the AD-AS model, a smallaggregate demandFigure 17.2increase leads to low inflation and high unemployment.t. Using aggregatedemand andA stronger AD increase results in lower unemploymentaggregate supplybut more inflationthe short run Phillips curveanalysistoexplainthePhillipscurverelationship.2015PearsonEducation,Inc.4of36
© 2015 Pearson Education, Inc. 4 of 36 Why Does the Phillips Curve Exist? In the AD-AS model, a small aggregate demand increase leads to low inflation and high unemployment. A stronger AD increase results in lower unemployment but more inflation—the short run Phillips curve relationship. Using aggregate demand and aggregate supply analysis to explain the Phillips curve Figure 17.2
Is the Phillips Curve a Policy Menu?Duringthe 1960s, some economists argued thatthe Phillips curvewas a structural relationship: a relationship that depends on thebasic behavior of consumers and firms, and that remains unchangedoverlong period.: In the 1960s, this relationship had appeared to be quite stableIf this was true, policy-makers could choose a point on the curve:trading permanently higher inflationforlower unemployment, or viceversa.But this turned out not to be true: allowing more inflation doesn'tlead to permanently lower unemployment.That is, the short-run Phillips curve moves over time2015PearsonEducation,Inc.5of36
© 2015 Pearson Education, Inc. 5 of 36 Is the Phillips Curve a Policy Menu? During the 1960s, some economists argued that the Phillips curve was a structural relationship: a relationship that depends on the basic behavior of consumers and firms, and that remains unchanged over long period. • In the 1960s, this relationship had appeared to be quite stable. If this was true, policy-makers could choose a point on the curve: trading permanently higher inflation for lower unemployment, or vice versa. • But this turned out not to be true: allowing more inflation doesn’t lead to permanently lower unemployment. • That is, the short-run Phillips curve moves over time
TheLong-RunPhillipsCurveBythelate1960s,Price levelLong-run(GDP deflator,aggregatemosteconomists2009=100)supplycurveagreed that thelong-run aggregatesupplycurve wasvertical.· Is a verticallong-run AScurvePotentialGDPcompatible withReal GDP0a downward-$17.0tillion(trillionsof2009 dollars)sloping long-runFigure 17.3aAvertical long-run aggregatesupplycurvePhillips curve?meansaverticallong-runPhillipscurveEconomists Milton Friedman and Edmund Phelps argued that thisimpliedthe long-run Phillips curve wasalso vertical: in the longrun,employment is determinedby output, whichinthe long run does notdepend on the price level.6of362015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 6 of 36 The Long-Run Phillips Curve By the late 1960s, most economists agreed that the long-run aggregate supply curve was vertical. • Is a vertical long-run AS curve compatible with a downwardsloping long-run Phillips curve? Economists Milton Friedman and Edmund Phelps argued that this implied the long-run Phillips curve was also vertical: in the long run, employment is determined by output, which in the long run does not depend on the price level. A vertical long-run aggregate supply curve means a vertical long-run Phillips curve Figure 17.3a
Natural Rateof UnemploymentSince employment wasInflationLong-runPhillipsratedetermined by potential GDP(percentcurveperyear)so must be unemployment.:Unemployment, in the longrun, goes to its natural rate,when the output returns topotential GDP.Natural rate ofunemployment: TheNaturalrateofunemploymentunemployment rate that exists05%Unemploymentwhen the economy is atrate (percent)potential GDP.Figure17.3bA vertical long-run aggregate supply curvemeansaverticallong-runPhillipscurveAt this output level, there is no cyclical unemployment; but theredoes remain structuraland frictionalunemployment.These lattertwoarenotpredictablyaffectedbyinflation.2015PearsonEducation,Inc.7of36
© 2015 Pearson Education, Inc. 7 of 36 Natural Rate of Unemployment Since employment was determined by potential GDP, so must be unemployment. • Unemployment, in the long run, goes to its natural rate, when the output returns to potential GDP. Natural rate of unemployment: The unemployment rate that exists when the economy is at potential GDP. At this output level, there is no cyclical unemployment; but there does remain structural and frictional unemployment. These latter two are not predictably affected by inflation. A vertical long-run aggregate supply curve means a vertical long-run Phillips curve Figure 17.3b
The Role of Expectationsof Future InflationHoweverthisconclusioncontradictedtheexperienceofthe1950sand1960s,duringwhichtimeastabletrade-off seemedtoexistbetween unemployment and inflation.: The short-run trade-off appears to exist because workers and firmssometimes expectthe inflationrate to beeitherhigher orlowerthanitturns outtobe.Suppose Ford and the United Auto Workers (UAW) agree to a wageof $34.65 perhour for2016.They expect the pricelevel to increasefrom110.0in2015to115.5in2015:5%inflation..Then $34.65 represents a real wage of $30.00:$34.65Nominal wageReal wage =-X100×100=$30105Pricelevel2015PearsonEducation,Inc.8of36
© 2015 Pearson Education, Inc. 8 of 36 The Role of Expectations of Future Inflation However this conclusion contradicted the experience of the 1950s and 1960s, during which time a stable trade-off seemed to exist between unemployment and inflation. • The short-run trade-off appears to exist because workers and firms sometimes expect the inflation rate to be either higher or lower than it turns out to be. Suppose Ford and the United Auto Workers (UAW) agree to a wage of $34.65 per hour for 2016. They expect the price level to increase from 110.0 in 2015 to 115.5 in 2015: 5% inflation. • Then $34.65 represents a real wage of $30.00: 100 $30 105 $34.65 100 Price level Nominal wage Real wage = = =
The Role of Expectations of Future Inflation-cont.Actual Real WageNominal WageExpectedReal WageExpectedP2016=115.5Actual P2016 = 112.2Actual P2016 = 118.8Expected inflation=5%Actual inflation=2%Actual inflation =8%$34.65$34.65$34.65x100=$30.00x100=$29.17$34.65x100=$30.88108105102Table 17.1Theeffectofunexpectedpricelevelchanges onthe real wageIf the expectations about inflation are correct, the real wage will be$30 as expected: Ford will hire its planned number of workers.But:If...then...and...actual inflation is greaterthe actual real wage is lessthe unemployment rate fallsthan expected inflation,than the expected real wageactualinflationislessthe actual real wage is greaterthe unemployment raterisesthanexpectedinflationthantheexpectedrealwageTable17.2Thebasisfortheshort-runPhillips curveFriedman: “There is always a temporary trade-off between inflation andunemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation."@2015PearsonEducation,Inc9of36
© 2015 Pearson Education, Inc. 9 of 36 The Role of Expectations of Future Inflation—cont. If the expectations about inflation are correct, the real wage will be $30 as expected; Ford will hire its planned number of workers. But: The effect of unexpected price level changes on the real wage Table 17.1 Nominal Wage Expected Real Wage Actual Real Wage Expected P2016 = 115.5 Expected inflation = 5% $34.65 100 $30.88 102 $34.65 = 100 $29.17 108 $34.65 100 $30.00 = 105 $34.65 = Actual P2016 = 118.8 Actual inflation = 8% Actual P2016 = 112.2 Actual inflation = 2% Friedman: “There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation.” Table 17.2 The basis for the short-run Phillips curve If. then. and. actual inflation is greater than expected inflation, the actual real wage is less than the expected real wage the unemployment rate falls actual inflation is less than expected inflation the actual real wage is greater than the expected real wage the unemployment rate rises
MakingDoWorkersUnderstandInflation?theConnection1Most economists believe anincrease in inflation willquicklyleadto anincreaseinwages.: However workers tend notto believe this, expectingthat inflation will decreasetheir purchasing power foryears,orevenpermanentlyThis has an important consequence: since workers do not expecttheir wages to increase with inflation, firms can increase wages byless than inflation (i.e. decrease real wages)without worrying aboutworkers quittingortheirmoralefalling. This gives a further reason why higher inflation will lead to lower(short-run) unemployment.10of362015Peion.lnc
© 2015 Pearson Education, Inc. 10 of 36 Making the Connection Do Workers Understand Inflation? Most economists believe an increase in inflation will quickly lead to an increase in wages. • However workers tend not to believe this, expecting that inflation will decrease their purchasing power for years, or even permanently. This has an important consequence: since workers do not expect their wages to increase with inflation, firms can increase wages by less than inflation (i.e. decrease real wages) without worrying about workers quitting or their morale falling. • This gives a further reason why higher inflation will lead to lower (short-run) unemployment