Chapter 22

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 and the vertical LRAS curve

Disinflationary Monetary Policy

Contractionary monetary policy moves economy from A to B.Over time, expected inflation falls, PC shifts downward.In the long run, point C: the natural rate of unemployment, lower inflation. page 20

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.

Reconciling Theory and Evidence

Evidence (from '60s): 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

The Volcker Disinflation

Fed Chairman Paul VolckerAppointed in late 1979 under high inflation & unemployment Changed Fed policy to disinflation1981-1984: 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...

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.

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.

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 BarroImplied that disinflation could be much less costly...

How an Adverse Supply Shock Shifts the PC

SRAS shifts left, prices rise, output & employment fall. Inflation & u-rate both increase as the PC shifts upward.

The Phillips Curve Equation

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 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 1960s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable.

Deriving the Phillips Curve

Suppose P = 100 this year. The following graphs show two possible outcomes for next year: A. Agg demand low, small increase in P (i.e., low inflation), low output, high unemployment. B. Agg demand high, big increase in P (i.e., high inflation), high output, low unemployment.

Summary 2

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.

Summary 1

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.

CONCLUSION

The theories in this chapter come from some of the greatest economists of the 20th 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

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.

Expected Inflation

a measure of how much people expect the price level to change.

Supply shock

an event that directly alters firms' costs and prices, shifting the AS and PC curves Example: large increase in oil prices

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 yearsacrifice 10% of GDP for three years

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."