Chapter 12
Unemployment
and Inflation
I.
Unemployment and Inflation: Is There a
Trade-off? (Sec. 12.1)
• A) Many people think there is a trade-off between
inflation and unemployment
• 1. The idea originated in 1958 when A.W. Phillips
showed a negative relationship between unemployment
and nominal wage growth in Britain
• 2. Since then economists have looked at the
relationship between unemployment and inflation
• 3. In the 1950s and 1960s many nations seemed to
have a negative relationship between the two variables
• 4. The United States appears to be on one Phillips
curve in the 1960s (text Figure 12.1)
B)
•
The expectations-augmented Phillips curve
Friedman and Phelps: The cyclical
unemployment rate depends only on
unanticipated inflation
a.
First case: anticipated increase in money
supply
• (1) AD shifts up and SRAS shifts up, with
no misperceptions
• (2) Result: P rises, Y unchanged
• (3) Inflation rises with no change in
unemployment
b.
Second case: unanticipated increase in money
supply
• Result: P rises and Y rises as misperceptions
occur
• So higher inflation occurs with lower
unemployment
• Long run: P rises further, Y declines to fullemployment level
c.
•
•
•
•
Expectations-augmented
Phillips curve:
 = e – h(u –un ) (12.1)
(1) When  = e, u =un
(2)When  < e, u > un
(3) When  > e, u < un
C) The shifting Phillips curve
• 1. The Phillips curve shows the
relationship between unemployment and
inflation for a given expected rate of
inflation and natural rate of unemployment
•
2. Changes in the expected rate of
inflation
3.
Changes in the natural rate of unemployment
• a. For a given natural rate of
unemployment, the Phillips curve shows
the trade-off between unemployment and
unanticipated inflation
• b. A higher natural rate of unemployment
shifts the Phillips curve to the right
4. Supply shocks and the Phillips
curve
• a. A supply shock increases both
expected inflation and the natural rate of
unemployment
• b. So an adverse supply shock shifts the
Phillips curve up and to the right
• c. The Phillips curve will be unstable in
periods with many supply shocks
5.
The shifting Phillips curve in practice
• a. Why did the original Phillips curve
relationship apply to many historical cases?
• b. Why did the U.S. Phillips curve
disappear after 1970?
D)
Macroeconomic policy and the Phillips curve
• 1. Can the Phillips curve be exploited by policymakers?
Can they choose the optimal combination of
unemployment and inflation?
• a.
Classical model: NO
• b.
Keynesian model: YES, temporarily
2. Box 12.1: The Lucas critique
• When the rules of the game change, behavior changes
• Lucas applied this idea to macroeconomics, arguing that
historical relationships between variables won’t hold up if
there’s been a major policy change
• Evaluating policy requires an understanding of how
behavior will change under the new policy, so both
economic theory and empirical analysis are necessary
E) The long-run Phillips curve
• 1. Long run: u = un for both Keynesians
and classicals
• 2. The long-run Phillips curve is vertical,
since when  = e, u = un (Figure 12.5;
like text Figure 12.8)
• 3. Changes in the level of money supply
have no long-run real effects; changes in
the growth rate of money supply have no
long-run real effects, either
II.
The Problem of Unemployment
• A) The costs of unemployment
• 1. Loss in output from idle resources
• 2. Personal or psychological cost to
workers and their families
• 3. There are some offsetting factors
B)
• 1.
• a.
The long-term behavior of the unemployment rate
The changing natural rate
How do we calculate the natural rate of unemployment?
• b. CBO’s estimates: 5% to 5½% today, similar to 1950s and
1960s; over 6% in 1970s and 1980s
• c.
Why did the natural rate rise from the 1950s to the late 1970s?
• d. Since 1980, demographic forces have reduced the natural rate
of unemployment
• e. Some economists think the natural rate of unemployment is
4.5% or even lower
• f.
Increased labor productivity may increase the natural rate of
unemployment
2.
Hysteresis in unemployment
• a. Europe’s unemployment rates rose dramatically
from the 1970s to the 1980s
• b. Hysteresis: The natural rate of unemployment rises
as the actual unemployment rate rises
• c. Caused partly by deteriorating skills of the
unemployed, which increases the mismatch problem
• d. Caused partly by restrictions on firms’ ability to fire
workers, making them reluctant to hire workers in good
times
• e. Caused partly by union-firm bargaining, as
suggested by insider-outsider theory
f.
Box 12.2: The effect of unemployment insurance on
unemployment
• (1) The rise in the natural rate of
unemployment is caused partly by the
unemployment insurance (UI) system
• (2) The longer duration of UI benefits in
Europe than in the United States accounts
• (3) But it doesn’t look like there’s much
evidence that higher UI benefits increase
the unemployment rate
C)
Policies to reduce the natural rate of unemployment
• 1. Government support for job training
and worker relocation
• 2. Increased labor market flexibility
• 3. Unemployment insurance reform
• 4. A high-pressure economy?
III.
The Problem of Inflation (Sec. 12.3)
• A) The costs of inflation
• 1. Perfectly anticipated inflation
• a. No effects if all prices and wages keep up
with inflation
• b. Even returns on assets may rise exactly with
inflation
• c. Shoe-leather costs: People spend resources
to economize on currency holdings; the
estimated cost of 10% inflation is 0.3% of GNP
• d. Menu costs: the costs of changing prices
(but technology may mitigate this somewhat sun
as the introduction of electronic scanners)
2.
Unanticipated inflation ( – e)
• a. Realized real returns differ from expected real
returns
• b. Similar effect on wages and salaries ( set in advance)
• c.
Result: transfer of wealth
• d. So people want to avoid risk of unanticipated
inflation
(2)
Box 12.3: Indexed contracts
• (a) People could use indexed contracts to avoid
the risk of transferring wealth
• (b) Most U.S. financial contracts are not indexed,
with the exception of some long-term contracts
• (c) Many U.S. labor contracts are indexed by
COLAs (cost-of-living adjustments)
• (d) Indexed contracts are more prevalent in
countries with high inflation
• (e.) Loss of valuable signals provided by prices
3.
The costs of hyperinflation
• a. Hyperinflation is a very high, sustained
inflation (for example, 50% or more per month)
• b. There are large shoe-leather costs, as
people minimize cash balances
• c. People spend many resources getting rid of
money as fast as possible
• d. Tax collections fall, as people pay taxes with
money whose value has declined sharply
• e. Prices become worthless as signals, so
markets become inefficient
B)
Fighting inflation: The role of inflationary
expectations
• 1. If rapid money growth causes inflation,
why do central banks allow the money
supply to grow rapidly?
• 2. Disinflation is a reduction in the rate of
inflation
• 3. The costs of disinflation could be
reduced if expected inflation fell at the
same time actual inflation fell
• 4. Rapid versus gradual disinflation
• a. The classical prescription for
disinflation is cold turkey
• (2) Keynesians disagree
• b. The Keynesian prescription for
disinflation is gradualism
5.
The sacrifice ratio
• a. When unanticipated tight monetary and fiscal
policies are used to reduce inflation, they reduce
output and employment for a time, a cost that
must be weighed against the benefits of lower
inflation
• b. Economists use the sacrifice ratio as a
measure of the costs
• c. Ball studied the sacrifice ratios for many
different disinflations around the world
• d. Ball’s results should be interpreted with
caution,
6.
Wage and price controls
• a. Pro: Controls would hold down inflation,
thus lowering expected inflation and
reducing the costs of disinflation
• b. Con: Controls lead to shortages and
inefficiency; once controls are lifted, prices
will rise again
• c. The outcome of wage and price
controls may depend on what happens
with fiscal and monetary policy
• d. The Nixon
7. Credibility and reputation
• a. Key determinant of the costs of
disinflation: how quickly expected inflation
adjusts
• b. This depends on credibility of
disinflation policy
• c. Credibility can be enhanced if the
government gets a reputation for carrying
out its promises
• d. Also, having a strong and independent
central bank that is committed to low
inflation provides credibility