Chapter 13
Unemployment and Inflation
Economics 282
University of Alberta
Unemployment and Inflation
• The Phillips curve is a negative empirical
relationship between unemployment and
inflation.
• In 1970-2003 there seemed to be no
reliable relationship between
unemployment and inflation.
The Expectations Augmented
Phillips Curve
• A negative relationship should exist
between unanticipated inflation and
cyclical unemployment.
The Phillips Curve (continued)
• If increase in M is anticipated, there is no
misperception, the economy remains at Y
, unemployment remains at u , cyclical
unemployment is zero.
The Phillips Curve (continued)
• If increase in M is unanticipated,
unanticipated inflation is created, Y is
above Y , u is below u .
π  π  h(u  u )
e
The Phillips Curve (continued)
• h measures the strength of the
relationship between unanticipated
inflation and cyclical unemployment.
The Phillips Curve (continued)
• The expectation-augmented Phillips curve
states that π exceeds πe if u is less than u .
π  π  h(u  u )
e
h is related to the slope of the SRAS curve.
Shifting of the Philips Curve
• The Phillips curve depends on the
expected rate of inflation and the natural
rate of unemployment. If either factor
changes the Phillips curve will shift.


π  π  hu  hu
e
Changes in the Expected Rate
of Inflation
• If households anticipate a change in the
price level they respond by their
expectations of the price level (the rate of
inflation) one-for-one.
• The Phillips curve shifts up by the amount
of the increase in the expected rate of
inflation.
Changes in the Natural Rate of
Unemployment
• An increase in the natural unemployment
rate causes the Phillips curve to shift up
and to the right.
Supply Shocks and the Phillips
Curve
• An adverse supply shock causes a burst
of inflation and raises the natural rate of
unemployment:
– by increasing the degree of mismatch
between workers and jobs (classical
economists);
– by reducing MPN and labour demanded at full
employment (Keynesian economists).
Supply Shocks and the Phillips
Curve
• An adverse supply shock should shift the
Phillips curve up and to the right.
• The Phillips curve should be particular
unstable during periods of supply shocks.
The Shifting Phillips Curve in
Practice
• The Friedman-Phelps analysis shows that
a negative relationship between the levels
of inflation and unemployment holds as
long as expected inflation and the natural
unemployment rate are approximately
constant.
The Shifting Phillips Curve in
Practice (continued)
• During 1970-2003 there was a number of
productivity shocks as well as changes in
government and macroeconomic policies.
• A negative relationship between
unanticipated inflation and cyclical
unemployment does appear in the data.
Macroeconomic Policy and the
Phillips Curve
• Keynesians believe that in a recession
expansionary AD policy can increase
inflation back to anticipated levels used as
a basis for nominal wage contracts and
pricing.
The Lucas Critique
• Because new policies change the
economic “rules” and, thus, affect
economic behaviour, no one can safely
assume that historical relationships
between variables will hold when policies
change.
The Long-Run Phillips Curve
• Economists agree that in the long run
economy will adjust to the general
equilibrium in which π=πe and u= u .
• The long-run Phillips curve is vertical line
at u= u . It is related to the long-run
neutrality of money.
The Cost of Unemployment
• The output is lost because fewer people
are productively employed.
• Unemployed workers and their families
face psychological cost.
• The offsetting factors are acquiring new
skills and more leisure time.
The Long-Term Behaviour of the
Unemployment Rate
• The overall unemployment rate may have
risen due to:
– changes in the composition of the labour force
by age and sex;
– structural changes in the economy;
– changes in employment insurance.
Hysteresis in Unemployment
• Hysteresis in unemployment means that
the natural unemployment rate changes in
response to the actual unemployment rate.
• If workers are idle for long periods of time
their skills deteriorate and the mismatch
increases.
Hysteresis in Unemployment
(continued)
• Due to regulations firms are more cautious
to hire workers because it is difficult to fire
them.
• The insider-outsider theory suggests that
unionized labour increases wages for
insiders and leaves outsiders unemployed.
How to Reduce the Natural
Rate of Unemployment
• Increase government support for job
training and reallocation.
• Increase labour market flexibility.
• Reform Employment Insurance
program.
• Use aggressive policy to keep actual
unemployment rate low.
Perfectly Anticipated Inflation
• Because nominal wages are rising
together with prices, the purchasing power
is not hurt by the perfectly anticipated
inflation.
• Perfectly anticipated inflation would not
hurt the value of savings accounts.
The Cost of Perfectly
Anticipated Inflation
• Shoe leather costs of inflation is time and
effort incurred by people and firms who
are trying to minimize their holdings of
cash.
• Menu costs of inflation.
• Welfare costs of inflation-induced tax
distortions.
The Cost of Unanticipated
Inflation
• Creditors and those with incomes set in
nominal terms are hurt, whereas debtors
and those who make fixed nominal
payments are helped by unanticipated
inflation.
The Cost of Unanticipated
Inflation (continued)
• People are made worse off by increasing
risk of gaining or losing wealth as a result
of unanticipated inflation.
• People must spend time and effort
learning about different prices.
The Cost of Hyperinflation
• Hyperinflation occurs when the inflation
rate is extremely high for a sustained
period of time.
– The shoe leather costs are enormous.
– The government’s ability to collect taxes is
undermined.
– The market efficiency is disrupted.
Fighting Inflation: The Role of
Inflationary Expectations
• The only factor that can create sustained
rises in aggregate demand and ongoing
inflation is a high rate of money growth.
• Governments may print money to finance
their spending or use unbalanced
monetary policy to fight recession.
Fighting Inflation (continued)
• The process of disinflation – the reduction
of money growth – leads to a serious
recession.
• If inflation falls below the expected rate,
unemployment will rise above the natural
rate.
• A recession can be avoided if expected
inflation rate can fall.
Rapid versus Gradual
Disinflation
• A cold turkey strategy is a rapid and
decisive reduction in the growth rate of
the money supply.
• It may lead to a significant increase in
cyclical unemployment.
Rapid versus Gradual
Disinflation (continued)
• Inflation expectations may not lower if the
government is expected to abandon the
policy under political pressure.
Rapid versus Gradual
Disinflation (continued)
• A policy of gradualism is a policy of
reducing the rate of money growth
gradually over a period of time.
Rapid versus Gradual
Disinflation (continued)
• This policy will raise unemployment by
less than the cold-turkey strategy, but the
period of higher unemployment will be
longer.
Wage and Price Controls
• Wage and price controls (income policies)
are legal limits on the ability of firms to
raise wages or prices.
• Price controls are likely to make
shortages.
• Wage-price controls have a major effect
on the public’s expectations.
Credibility and Reputation
• The expected inflation adjusts quickly if
government’s announced disinflationary
policy is credible.
• Policymakers increase their credibility by
developing reputation for carrying through
on their promises.
Credibility and Reputation
(continued)
• A strong and independent central bank
creates credibility of monetary policy with
the public.
End of Chapter