The Short-Run
Tradeoff between
Inflation and
Unemployment
Chapter 33
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Unemployment and Inflation
◆ The

natural rate of unemployment
depends on various features of the
labor market.
◆ Examples include minimum-wage laws,
the market power of unions, the role of
efficiency wages, and the effectiveness
of job search.

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Unemployment and Inflation
◆ The

inflation rate depends primarily
on growth in the quantity of money,

controlled by the Fed.

◆

The misery index, one measure of the
“health” of the economy, adds together
the inflation rate and unemployment
rate.

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Unemployment and Inflation
Society faces a short-run tradeoff between
unemployment and inflation.
◆ If policymakers expand aggregate
demand, they can lower unemployment,
but only at the cost of higher inflation.
◆ If they contract aggregate demand, they
can lower inflation, but at the cost of
temporarily higher unemployment.
◆

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The Phillips Curve
The Phillips curve illustrates the
short-run relationship between
inflation and unemployment.


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The Phillips Curve...
Inflation
Rate
(percent
per year)
B

6

A

2

Phillips curve
0

4

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7

Unemployment
Rate (percent)



Aggregate Demand, Aggregate
Supply, and the Phillips Curve
◆

The Phillips curve shows the short-run
combinations of unemployment and
inflation that arise as shifts in the
aggregate demand curve move the
economy along the short-run aggregate
supply curve.

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Aggregate Demand, Aggregate
Supply, and the Phillips Curve
The greater the aggregate demand for
goods and services, the greater is the
economy’s output, and the higher is the
overall price level.
◆ A higher level of output results in a lower
level of unemployment.
◆

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How the Phillips Curve is Related to the Model
of Aggregate Demand and Aggregate Supply...
(a) The Model of AD and AS

Price Level

Short-run
AS

102

0

Inflation Rate
(percent per
year)

B

106
A

7,500
(unemployment
is 7%)

(b) The Phillips Curve

High AD

B

6


Low AD

2

8,000
(unemployment
is 7%)

0

A
7
4
(output is (output is
8,000)

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7,500)

Phillips curve
Unemployment
Rate (percent)


Shifts in the Phillips Curve:
The Role of Expectations
The Phillips curve seems to offer
policymakers a menu of possible
inflation and unemployment outcomes.


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The Long-Run Phillips Curve
◆ In the 1960s, Friedman and Phelps

concluded that inflation and
unemployment are unrelated in the long
run.
As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
◆ Monetary policy could be effective in the
short run but not in the long run.
◆

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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

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Long-run
Phillips curve
B

A

Natural rate of
unemployment

2. … but
unemployment
remains at its
natural rate
in the long run.

Unemployment
Rate



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How the Phillips Curve is Related to the
Model of Aggregate Demand and
Aggregate Supply…
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level

Long-run aggregate
supply

(b) The Phillips Curve
Inflation
Rate

P2

1. An increase in the
money supply increases
aggregate demand…

P1

AD2

Long-run Phillips

curve

B

3. …and
increases the
inflation rate…

A

Aggregate
demand, AD1
0
2. …raises the
price level…

Natural rate of
output

Quantity of
Output

0

Natural rate of
unemployment

4. …but leaves output and unemployment
at their natural rates.


Unemployment Rate


Expectations and the
Short-Run Phillips Curve
Expected inflation measures
how much people expect the
overall price level to change.

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Expectations and the
Short-Run Phillips Curve
◆ In

the long run, expected inflation
adjusts to changes in actual inflation.
◆ The Fed’s ability to create unexpected
inflation exists only in the short run.
◆

Once people anticipate inflation, the only
way to get unemployment below the natural
rate is for actual inflation to be above the
anticipated rate.

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Expectations and the
Short-Run Phillips Curve
Unemployment
Rate

=

Natural rate of
unemployment

- a(

Actual -Expected
inflation inflation

This equation relates the
unemployment rate to the natural
rate of unemployment, actual
inflation, and expected inflation.

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)


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How Expected Inflation Shifts the
Short-Run Phillips Curve...
Inflation

Rate

Long-run
Phillips curve

B

1. Expansionary
policy moves
the economy up
along the shortrun Phillips
curve...

0

2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
curve shifts to the right.

C

Short-run Phillips curve with
high expected inflation

A

Short-run Phillips curve with
low expected inflation


Natural rate of
unemployment

Unemployment
Rate


The Natural-Rate Hypothesis
The view that unemployment eventually
returns to its natural rate, regardless of
the rate of inflation, is called the
natural-rate hypothesis.
◆ Historical observations support the
natural-rate hypothesis.
◆

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The Natural Experiment for the
Natural Rate Hypothesis
The concept of a stable Phillips curve
broke down in the in the early ’70s.
◆ During the ’70s and ’80s, the economy
experienced high inflation and high
unemployment simultaneously.
◆

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The Phillips Curve in the 1960s...
Inflation Rate
(percent per year)
10

8

6
1968
4

1967

1966

1965
2
0

1

1962
1964

1963

1961

2

3
4
5
6
7
8
Unemployment Rate (percent)

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9

10


The Breakdown of the Phillips Curve...
Inflation Rate
(percent per year)
10

8
1973
6

1969
1968

4

1967


1971
1970 1972
1966

1965
2
0

1

1962
1964

1963

1961

2
3
4
5
6
7
8
Unemployment Rate (percent)

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9


10


Shifts in the Phillips Curve:
The Role of Supply Shocks
◆

Historical events have shown that the
short-run Phillips curve can shift due to
changes in expectations.

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Shifts in the Phillips Curve:
The Role of Supply Shocks
◆

The short-run Phillips curve also shifts
because of shocks to aggregate supply.
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.
◆

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Shifts in the Phillips Curve:
The Role of Supply Shocks
A supply shock is an event that directly
affects firms’ costs of production and
thus the prices they charge.
◆ It shifts the economy’s aggregate
supply curve...
◆ … and as a result, the Phillips curve.
◆

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An Adverse Shock to Aggregate
Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level

3. …and raises the
price level…
AS2

P2

0


Inflation
Rate

Aggregate
supply, AS1

A

A
PC2

Aggregate
demand
Y2

Y1

Quantity of
Output

2. …lowers output…
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4. …giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B

1. An adverse

shift in aggregate
supply…

B

P1

(b) The Phillips Curve

0

Phillips curve, PC1
Unemployment
Rate