Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Phillips Curve
The Relationship Between Inflation and Unemployment
•An inverse relationship between inflation and unemployment
until the 1970s
•1970s high inflation and unemployment
•Is there still a relationship between inflation and
unemployment?
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The 1960s: A Policy Menu?
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Discovery of the Short-Run Trade-off
between Unemployment and Inflation
Phillips curve A curve showing the shortrun relationship between the unemployment
rate and the inflation rate.
The Phillips Curve
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Discovery of the Short-Run Trade-off
between Unemployment and Inflation
Explaining the Phillips Curve with Aggregate
Demand and Aggregate Supply Curves
Using Aggregate Demand
and Aggregate Supply to
Explain the Phillips Curve
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
1970s: Why did the Phillips curve vanish?
higher oil prices
inflation became persistent and positive
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
Is the Phillips Curve a Policy Menu?
Is the Short-Run Phillips Curve Stable?
During the 1960s, the basic Phillips curve relationship seemed to
hold because a stable trade-off appeared to exist between
unemployment and inflation.
Then in 1968, in his presidential address to the American Economic
Association, Milton Friedman of the University of Chicago argued
that the Phillips curve did not represent a permanent trade-off
between unemployment and inflation.
The Long-Run Phillips Curve
Natural rate of unemployment The unemployment
rate that exists when the economy is at potential GDP.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Long-Run Phillips Curve
Natural rate of unemployment The unemployment
rate that exists when the economy is at potential GDP.
A Vertical Long-Run Aggregate Supply Curve
Means a Vertical Long-Run Phillips Curve
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Role of Expectations of Future Inflation
The Basis for the Short-Run Phillips Curve
IF…
THEN…
AND…
actual inflation is
greater than
expected
inflation,
the actual real wage is
less than the expected
real wage,
labor is cheap …
the unemployment rate
falls.
actual inflation is
less than
expected
inflation,
the actual real wage is
greater than the
expected
real wage,
labor is dear …
the unemployment rate
rises.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Short-Run and Long-Run Phillips Curves
The Short-Run Phillips
Curve of the 1960s and the
Long-Run Phillips Curve
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
The Short-Run and Long-Run Phillips Curves
The Inflation Rate and the
Natural Rate of Unemployment
in the Long Run
Nonaccelerating
inflation rate of
unemployment (NAIRU)
The unemployment rate
at which the inflation rate
has no tendency to
increase or decrease.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
Making
the
Connection
Does the Natural Rate of
Unemployment Ever Change?
Frictional or structural unemployment can change—
thereby changing the natural rate—for several reasons:
• Demographic changes.
• Labor market institutions.
Strength of unions
Generous unemployment benefits
• Past high rates of unemployment.
• Other costs of production and the real wage
Oil price and the “natural rate”
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
Expectations of the Inflation Rate
and Monetary Policy
The experience in the United States over the past 50 years
indicates that how workers and firms adjust their expectations of
inflation depends on how high the inflation rate is. There are
three possibilities:
• Low inflation.
• Moderate but stable inflation.
• High and unstable inflation.
Rational expectations
Expectations formed by using
all available information about
an economic variable.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
Expectations of the Inflation Rate and Monetary Policy
The Effect of Rational Expectations on Monetary Policy
Rational Expectations
and the Phillips Curve
Rational expectations
Expectations formed by
using all available
information about an
economic variable, including
what you’ve learned in
college.
Real business
cycle models
Models that
focus on real
rather than
monetary
explanations of
fluctuations in
real GDP.
Rational expectations
 Policy ineffectiveness
 Don’t bother with
expansionary policy
 Laissez - faire
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
Is the Short-Run Phillips Curve Really Vertical?
Many economists remain skeptical that the short-run Phillips
curve is vertical.
(1) workers and firms actually may not have rational
expectations, and
(2) the rapid adjustment of wages and prices needed for
the short-run Phillips curve to be vertical will not
actually take place.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
How the Fed Fights Inflation
Paul Volcker and Disinflation
The Fed Tames Inflation,
1979–1989
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
FEDERAL RESERVE CHAIRMAN
TERM
AVERAGE
ANNUAL INFLATION
RATE DURING TERM
William McChesney Martin
April 1952-January 1970
2.0%
Arthur Burns
February 1970-January 1978
6.5
G. William Miller
March 1978-August 1979
9.2
Paul Volcker
August 1979-August 1987
6.2
Alan Greenspan
August 1987-(January 2006)
3.0
Ben Bernanke
January 2006–
3.0
How the Fed Fights Inflation
De-emphasizing the Money Supply
The Fed learned an important lesson during the1970s:
Workers, firms, and investors in stock and bond markets have
to view Fed announcements as credible if monetary policy is
to be effective.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
How the Fed Fights Inflation
Monetary Policy Credibility after Greenspan
Central banks are more credible if they adopt and follow
rules.
Rules (e.g., Taylor Rule) vs. discretion
A middle course between rules and discretion:
Inflation targeting.
The best way to achieve commitment to rules
 remove political pressures on the central bank.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
An Inside LOOK
The Fed Rethinks the Phillips Curve
Policy Makers at Fed Rethink Inflation’s Roots
The short- and long-run Phillips curves.
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Chapter 16: Inflation, Unemployment, and Federal Reserve Policy
Key Terms
Disinflation
Natural rate of unemployment
Nonaccelerating inflation rate of
unemployment (NAIRU)
Phillips curve
Rational expectations
Real business cycle models
Structural relationship
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