1) The document discusses the short-run tradeoff between inflation and unemployment according to the Phillips curve. It explains how monetary policy can impact the rate of inflation and unemployment in the short-run. 2) In the long-run, inflation and unemployment return to their natural rates. Expected inflation, supply shocks, and shifts in aggregate demand can cause the Phillips curve to shift. 3) Reducing inflation requires contractionary monetary policy that lowers aggregate demand. This increases unemployment in the short-run according to movements along the Phillips curve.

1. Copyright © 2004 South-Western
3535The Short-Run
Tradeoff between
Inflation and
Unemployment

2. Copyright © 2004 South-Western
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.
• The inflation rate depends primarily on growth
in the quantity of money, controlled by the Fed.

3. Copyright © 2004 South-Western
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.

4. Copyright © 2004 South-Western
THE PHILLIPS CURVE
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.

5. Figure 1 The Phillips Curve
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Phillips curve
4
B6
7
A
2
Copyright © 2004 South-Western

6. Copyright © 2004 South-Western
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.

7. Copyright © 2004 South-Western
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.

8. Figure 2 How the Phillips Curve is Related to
Aggregate Demand and Aggregate Supply
Quantity
of Output
0
Short-run
aggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Price
Level
(b) The Phillips Curve
Phillips curve
Low aggregate
demand
High
aggregate demand
(output is
8,000)
B
4
6
(output is
7,500)
A
7
2
8,000
(unemployment
is 4%)
106 B
(unemployment
is 7%)
7,500
102 A
Copyright © 2004 South-Western

9. Copyright © 2004 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF EXPECTATIONS
• The Phillips curve seems to offer policymakers
a menu of possible inflation and unemployment
outcomes.

10. Copyright © 2004 South-Western
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.

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

12. Figure 4 How the Phillips Curve is Related to
Aggregate Demand and Aggregate Supply
Quantity
of Output
Natural rate
of output
Natural rate of
unemployment
0
Price
Level
P
Aggregate
demand, AD
Long-run aggregate
supply
Long-run Phillips
curve
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
2. . . . raises
the price
level . . .
1. An increase in
the money supply
increases aggregate
demand . . .
A
AD2
B
A
4. . . . but leaves output and unemployment
at their natural rates.
3. . . . and
increases the
inflation rate . . .
P2
B
Copyright © 2004 South-Western

13. Copyright © 2004 South-Western
Expectations and the Short-Run Phillips
Curve
• Expected inflation measures how much people
expect the overall price level to change.

14. Copyright © 2004 South-Western
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.

15. Copyright © 2004 South-Western
• This equation relates the unemployment rate to
the natural rate of unemployment, actual
inflation, and expected inflation.
Expectations and the Short-Run Phillips
Curve
( )N a t u r a l r a t e o f u n e m p l o y m e n t - a A c t u a l
i n f l a t i o n
E x p e c t e d
i n f l a t i o n−
Unemployment Rate =

16. Figure 5 How Expected Inflation Shifts the Short-
Run Phillips Curve
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate Long-run
Phillips curve
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
C
B
A
Copyright © 2004 South-Western

17. Copyright © 2004 South-Western
The Natural Experiment for 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.

18. Copyright © 2004 South-Western
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.

19. Figure 6 The Phillips Curve in the 1960s
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1968
1966
1961
1962
1963
1967
1965
1964
Copyright © 2004 South-Western

20. Figure 7 The Breakdown of the Phillips Curve
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1973
1966
1972
1971
1961
1962
1963
1967
1968
1969 1970
1965
1964
Copyright © 2004 South-Western

21. Copyright © 2004 South-Western
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.

22. Copyright © 2004 South-Western
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.

23. Copyright © 2004 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• 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.

24. Figure 8 An Adverse Shock to Aggregate Supply
Quantity
of Output
0
Price
Level
Aggregate
demand
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
3. . . . and
raises
the price
level . . .
AS2
Aggregate
supply, AS
A
1. An adverse
shift in aggregate
supply . . .
4. . . . giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
BP2
Y2
P
A
Y
Phillips curve,PC
2. . . . lowers output . . .
PC2
B
Copyright © 2004 South-Western

25. Copyright © 2004 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• In the 1970s, policymakers faced two choices
when OPEC cut output and raised worldwide
prices of petroleum.
• Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
• Fight inflation by contracting aggregate demand
and endure even higher unemployment.

26. Figure 9 The Supply Shocks of the 1970s
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1972
19751981
1976
1978
1979
1980
1973
1974
1977
Copyright © 2004 South-Western

27. Copyright © 2004 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, the Fed has to pursue
contractionary monetary policypolicy.
• When the Fed slows the rate of money growth,
it contracts aggregate demand.
• This reduces the quantity of goods and services
that firms produce.
• This leads to a rise in unemployment.

28. Figure 10 Disinflationary Monetary Policy in the
Short Run and the Long Run
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate
Long-run
Phillips curve
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Contractionary policy moves
the economy down along the
short-run Phillips curve . . .
2. . . . but in the long run, expected
inflation falls, and the short-run
Phillips curve shifts to the left.
BC
A
Copyright © 2004 South-Western

29. Copyright © 2004 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, an economy must endure a
period of high unemployment and low output.
• When the Fed combats inflation, the economy
moves down the short-run Phillips curve.
• The economy experiences lower inflation but at the
cost of higher unemployment.

30. Copyright © 2004 South-Western
THE COST OF REDUCING
INFLATION
• The sacrifice ratio is the number of percentage
points of annual output that is lost in the
process of reducing inflation by one percentage
point.
• An estimate of the sacrifice ratio is five.
• To reduce inflation from about 10% in 1979-1981
to 4% would have required an estimated sacrifice of
30% of annual output!

31. Copyright © 2004 South-Western
Rational Expectations and the Possibility of
Costless Disinflation
• The theory of rational expectations suggests
that people optimally use all the information
they have, including information about
government policies, when forecasting the
future.

32. Copyright © 2004 South-Western
Rational Expectations and the Possibility of
Costless Disinflation
• Expected inflation explains why there is a
tradeoff between inflation and unemployment
in the short run but not in the long run.
• How quickly the short-run tradeoff disappears
depends on how quickly expectations adjust.

33. Copyright © 2004 South-Western
Rational Expectations and the Possibility of
Costless Disinflation
• The theory of rational expectations suggests
that the sacrifice-ratio could be much smaller
than estimated.

34. Copyright © 2004 South-Western
The Volcker Disinflation
• When Paul Volcker was Fed chairman in the
1970s, inflation was widely viewed as one of
the nation’s foremost problems.
• Volcker succeeded in reducing inflation (from
10 percent to 4 percent), but at the cost of high
employment (about 10 percent in 1983).

35. Figure 11 The Volcker Disinflation
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1980 1981
1982
1984
1986
1985
1979
A
1983
B
1987
C
Copyright © 2004 South-Western

36. Copyright © 2004 South-Western
The Greenspan Era
• Alan Greenspan’s term as Fed chairman began
with a favorable supply shock.
• In 1986, OPEC members abandoned their
agreement to restrict supply.
• This led to falling inflation and falling
unemployment.

37. Figure 12 The Greenspan Era
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1984
1991
1985
1992
1986
1993
1994
1988
1987
1995
1996
20021998
1999
2000
2001
1989
1990
1997
Copyright © 2004 South-Western

38. Copyright © 2004 South-Western
The Greenspan Era
• Fluctuations in inflation and unemployment in
recent years have been relatively small due to
the Fed’s actions.

39. Copyright © 2004 South-Western
Summary
• The Phillips curve describes a negative
relationship between inflation and
unemployment.
• By expanding aggregate demand, policymakers
can choose a point on the Phillips curve with
higher inflation and lower unemployment.
• By contracting aggregate demand,
policymakers can choose a point on the Phillips
curve with lower inflation and higher
unemployment.

40. Copyright © 2004 South-Western
Summary
• The tradeoff between inflation and
unemployment described by the Phillips curve
holds only in the short run.
• The long-run Phillips curve is vertical at the
natural rate of unemployment.

41. Copyright © 2004 South-Western
Summary
• The short-run Phillips curve also shifts because
of shocks to aggregate supply.
• An adverse supply shock gives policymakers a
less favorable tradeoff between inflation and
unemployment.

42. Copyright © 2004 South-Western
Summary
• When the Fed contracts growth in the money
supply to reduce inflation, it moves the
economy along the short-run Phillips curve.
• This results in temporarily high unemployment.
• The cost of disinflation depends on how
quickly expectations of inflation fall.