Inflation and Unemployment

Inflation, Unemployment and the Phillips Curve

Two goals of economic policymakers are low inflation and low

unemployment, but often these goals conflict.

Suppose that policymakers were to use monetary or fiscal policy

to expand aggregate demand. This policy would move the
economy along the short-run aggregate supply (SRAS) curve to
a point of higher output and a higher price level. Higher output
means lower unemployment, because firms employ more
workers when they produce more. A higher price level, given
the previous (years) price level, means higher inflation.

Thus, when policymakers move the economy up along the SRAS

curve, they reduce the unemployment rate and raise inflation
rate. In other words, in the short run, society faces a trade-off
between inflation and unemployment.
2

Inflation, Unemployment and the Phillips Curve

Phillips curve: shows the short-run trade-off between inflation

and unemployment

1958: New Zealand born economist 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.

Inflation, Unemployment and the Phillips Curve

The Phillips curve that economists use today differs in three

ways from the relationship Phillips examined.
a)

The modern Phillips curve substitutes price inflation for wage

inflation. This difference is trivial, since price inflation and wage
inflation are closely related. In periods when wages are rising
quickly, prices are rising quickly as well.

b)

The modern Phillips curve includes expected inflation. This

addition is due to the work of Milton Friedman and Edmund
Phelps, who during the 1960s have emphasized the importance
of expectations for aggregate supply.

c)

The modern Phillips curve includes supply shocks. Credit for this
addition goes to OPEC, which in 1970s caused large increases in
the world price of oil, which made economists more aware of the
importance of shocks to aggregate supply.
4

Inflation, Unemployment and the Phillips Curve

The above three forces are expressed in the following

equation:
e

(u u )
where > 0 is an exogenous constant, which measures the
response of inflation to cyclical unemployment. The minus sign
(before cyclical unemployment term) indicates that other
things equal, higher unemployment is associated with lower
inflation.
For the derivation of Phillips curve, you may refer to Mankiw,
Macroeconomics (6th edition): Chapter 13, pp. 385-387.
5

Adaptive Expectations and Inflation Inertia

What determines expected inflation?

A simple and plausible assumption is that people form their

expectations of inflation based on recently observed inflation. This
assumption is called adaptive expectations.

A simple example:
Expected inflation = last years actual inflation, i.e.,

e 1

Then, the Phillips curve becomes

1 (u u n )

When the Phillips curve is written in this form, the natural rate
of unemployment is sometimes called the Non-Accelerating Rate
of Unemployment, or NAIRU
6

Adaptive Expectations and Inflation Inertia

In this form, the Phillips curve implies that inflation has inertia:

In the absence of supply shocks or cyclical unemployment,

inflation will continue indefinitely at its current rate, unless
something acts to stop it. In particular, if unemployment is at
the NAIRU and if there are no supply shocks, the continued
rise in the price level neither speeds up nor slows down.
Past inflation influences expectations of current inflation,
which in turn influences the wages & prices that people set.

Supply Shock

supply shock: an event that directly alters firms costs and

prices, shifting the economys aggregate-supply curve and thus
the Phillips curve.

Examples of adverse supply shocks:

Bad weather reduces crop yields, pushing up food prices

Workers unionize, negotiate wage increases

New environmental regulations require firms to reduce emissions.

Firms charge higher prices to help cover the costs of compliance

Graphically, we could represent these supply shocks as a shift in

the short-run aggregate-supply curve to the left

The decrease in equilibrium output and the increase in the price

level left the economy with stagflation (high inflation with low
output and employment).
8

Supply Shock

Given this turn of events, policymakers are left with a less

favorable short-run trade-off between unemployment and
inflation.
If they increase aggregate demand to fight unemployment,
they will raise inflation further.
If they lower aggregate demand to fight inflation, they will
raise unemployment further.

The 1970s Oil Shock

OPEC (Organization of Petroleum Exporting Countries) is a cartel,

which is an organization of suppliers that coordinate production levels
and prices.

OPEC first demonstrated its muscle in 1974: in the aftermath of a war

in the Middle East (Yom Kippur War), several OPEC producers limited
their output - referred to as Arab Oil embargo.

Oil prices
11%
68%
16%

Such sharp oil price increases are supply shocks because they
significantly impact production costs and prices (Oil is required
to heat the factories in which goods are produced, and to fuel
the trucks that transport the goods from the factories to the
warehouses to Retail stores. A sharp increase in the price of
oil, therefore, has a substantial effect on production costs).

rose
in 1973
in 1974
in 1975

10

The 1970s Oil Shock

Predicted effects of the oil
shock:
inflation
output
unemployment
and then a gradual
recovery (In absence of
further price shocks,
prices will fall over time
and economy moves back
toward full employment).

70%

12%

60%
50%

10%

40%
8%

30%
20%

6%

10%
0%
1973

1974

1975

1976

4%
1977

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)

11

The 1970s Oil Shock

Late 1970s:
60%

As economy was
recovering, oil prices
shot up again,
causing another
huge supply shock!!!
This second shock was
associated with the revolution in
Iran. The Shah, who maintained
cordial relations with the West,
was deposed. The new leader,
Ayatollah Khomeini, was
considerably less friendly toward
the West. (He even forbade his
citizens from listening to
Western music.)

14%

50%

12%

40%
10%
30%
8%
20%
6%

10%

4%

0%
1977

1978

1979

1980

1981

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)

12

The 1980s Oil Euphoria

By the mid-1980s, however,
there was a growing glut of oil
on world markets, and cheating
by cash-short OPEC members
became widespread. The result,
in 1985, was that producers
who had tried to play by the
rules especially Saudi Arabia,
the largest producer got fed
up, and collusion collapsed.
As the model predicts,
inflation and unemployment fell

10%

40%
30%

8%

20%
10%

6%

0%
-10%

4%

-20%
-30%

2%

-40%
-50%
1982

0%
1983

1984

1985

1986

1987

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)

13

Two causes of rising & falling inflation

cost-push inflation: inflation resulting from supply shocks

Adverse supply shocks typically raise production costs and induce

firms to raise prices, pushing inflation up.

demand-pull inflation: inflation resulting from demand shocks

Positive shocks to aggregate demand cause unemployment to fall

below its natural rate, which pulls the inflation rate up.

Of course, a favorable supply shock that lowers production

costs will push inflation down, and a negative demand shock
which raises cyclical unemployment will pull inflation down.

14

Graphing the Phillips Curve

In the short run,
policymakers face
a tradeoff between
and u.
Here, the short
run is the period
until people adjust
their expectations
of inflation

e (u u n )

The shortrun Phillips

curve

15

Shifting the Phillips Curve

People adjust
their expectations
over time, so the
tradeoff only
holds in the short
run.
E.g., an
increase
in e shifts the
short-run P.C.
upward.

e (u u n )

2e
1e

u
16

Shifting the Phillips Curve

Show what happens to the Phillips Curve in the face of an
increase in the natural rate of unemployment

At any given value of actual unemployment, an increase in the

natural rate implies a decrease in cyclical unemployment, which
increases inflation by increasing pressures for wages to rise.
Thus, each value of unemployment has a higher value of
inflation than before.

Try Yourself! What happens to the Phillips Curve in the face of

an adverse supply shock?

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The Sacrifice Ratio

To reduce inflation, policymakers can contract aggregate

demand, causing unemployment to rise above the natural rate.

The sacrifice ratio measures the percentage of a years real GDP

that must be foregone to reduce inflation by 1 percentage point.

A typical estimate of the ratio for the US economy is 5.

Example: To reduce inflation from 6 to 2 percent, must sacrifice

20 percent of one years GDP:
GDP loss = (inflation reduction) x (sacrifice ratio)
=
4
x
5

This loss could be incurred in one year or spread over several,

e.g., 5% loss for each of four years.

The cost of disinflation is lost GDP.

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Rational Expectations
Ways of modeling the formation of expectations:

adaptive expectations: People base their expectations of future

inflation on recently observed inflation.
rational expectations: People base their expectations on all available
information, including information about current and prospective future
policies.
Suppose the RBI announces a shift in priorities, from maintaining low
inflation to maintaining low unemployment w/o regard to inflation; this
shift will start affecting policy next week
If expectations are adaptive, then expected inflation will not
change, because it is based on past inflation. The RBIs
announcement pertains to the future, and has no impact on past
inflation.
If expectations are rational, then expected inflation will increase
right away, as people factor this announcement into their
forecasts.
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Painless disinflation

Proponents of rational expectations believe that the sacrifice

ratio may be very small.

They believe if policymakers are credibly committed to reducing

inflation, rational people will understand the commitment and
will quickly lower their expectations. Workers will demand lower
wages while entering into a labour contract and firms that must
announce prices in advance will announce lower prices than if
they expected higher inflation; thereby reducing the wage-price
spiral. Inflation can then come down without a rise in
unemployment and fall in output.

Central banks that are politically independent are typically more

credible than those that are puppets to elected officials.
Hence, in countries with central banks that are NOT politically
independent, it is usually far costlier to reduce inflation. A very
worthwhile reform, therefore, would be for governments to give
their central banks independence.
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Painless disinflation

In the most extreme case, one can imagine reducing the rate of
inflation without causing any recession at all.

A painless disinflation has two requirements:

First, the plan to reduce inflation must be announced before workers and
firms that set wages and prices have formed their expectations.
Second, the workers and firms must believe the announcement; otherwise,
they will not reduce their expectations of inflations.

If both requirements are met, the announcement will immediately shift

the short-run tradeoff between inflation and unemployment downward,
permitting a lower rate of inflation without higher unemployment.

Almost all economists agree that expectations of inflation influence the

short-run tradeoff between inflation and unemployment. The credibility
of a policy to reduce inflation is therefore one determinant of how costly
the policy will be. Unfortunately, it is often difficult to predict whether
the public will view the announcement of the policy as credible.
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Case 1: Volcker Disinflation

1981: = 9.7%
1985: = 3.0%

Total disinflation = 6.7%

22

Case 2: Volcker Disinflation

From previous slide: Inflation fell by 6.7%, total cyclical

unemployment was 9.5%.

Okuns law:
1% of unemployment = 2% of lost output.

So, 9.5% cyclical unemployment = 19.0% of a years real GDP.

Sacrifice ratio = (lost GDP)/(total disinflation)

= 19/6.7 = 2.8 percentage points of GDP were lost
for each 1 percentage point reduction in inflation.

The sacrifice ratio was smaller than earlier estimates. One

explanation is that Volckers tough stand was credible enough to
influence expectations of inflation directly. Yet the change in
expectations was not large enough to make the disinflation
painless: in 1982 unemployment reached its highest level since
the Great Depression.
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Case 2: Recovery of Japanese Slump

Attempts

to stimulate the economy with monetary

expansion were too slow to avoid deflation, leaving Japan in
a liquidity trap. Japans nominal interest rate was near zero
from 1999 until 2003. As a result, conventional monetary
policy was powerless to stimulate the economy.
Government

spending increased, mainly in the form of

public works projects. Fiscal stimulus presumably had some
positive effect on output, but not enough to overturn the
deflation. Moreover, government deficits increased Japan's
government debt to GDP ratio to 85% in 2004. This created
the potential for a substantial debt service burden if the
interest rate on government debt increases in the future. In
this situation, Japanese officials were reluctant to attempt
additional fiscal expansion.
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Case 2: Recovery of Japanese Slump

Output

growth has been higher since 2003, and most

economists cautiously predict that the recovery will continue.
What

are the factors behind the current recovery?

Japan had some good luck in particular an increase in

export demand from China but also some good policy,
which Japan appears to have adopted since 2003.

25

Case 2: Recovery of Japanese Slump

It

is suggested that even if the nominal interest rate is already

equal to zero and thus cannot be reduced further, the central bank
might still be able to lower the real interest rate by increasing
inflation expectations.

To

increase expected inflation, the Bank of Japan would have to

convince the public that it planned to generate inflation in the
future, perhaps by announcing target inflation rates. The success of
such a policy depends on whether it is believed.

In

2003, the Bank of Japan announced that it would keep nominal

interest rates at 0% until there was strong evidence of sustained
inflation. This announcement was taken as a signal of the Bank of
Japans intention to create the necessary inflation to pull the
economy out of its slump. Although inflation remains negative,
expected inflation is positive, and the long term real interest rate
has fallen, a factor that has probably contributed to the increase in
investment spending since 2003.

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