1、 2009 South-Western,a part of Cengage Learning,all rights reservedC H A P T E REconomicsPremium PowerPoint Slides by Ron Cronovich22How are inflation and unemployment related in the short run?In the long run?What factors alter this relationship?What is the short-run cost of reducing inflation?Why we
2、re U.S.inflation and unemployment both so low in the 1990s?1 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF2IntroductionIn the long run,inflation&unemployment are unrelated:The inflation rate depends mainly on growth in the money
3、supply.Unemployment(the“natural rate”)depends on the minimum wage,the market power of unions,efficiency wages,and the process of job search.One of the Ten Principles:In the short run,society faces a trade-off between inflation and unemployment.2009 South-Western Principles of Macroeconomics,by N.G.M
4、ankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF3(1)The Phillips Curve 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF4The Phillips CurvePhillips curve:shows the short-run trade-off between inflation and unemployment 19
5、58:A.W.Phillips showed that nominal wage growth was negatively correlated with unemployment in the U.K.1960:Paul Samuelson&Robert Solow found a negative correlation between U.S.inflation&unemployment,named it“the Phillips Curve.”2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C
6、/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF5Deriving the Phillips CurveSuppose P=100 this year.The following graphs show two possible outcomes for next year:A.Aggregate demand low,small increase in P(i.e.,low inflation),low output,high unemployment.B.Aggregate demand high,big increase in P(i.e.,hi
7、gh inflation),high output,low unemployment.2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF6Deriving the Phillips Curveu-rateinflationPCA.Low aggregate demand,low inflation,high u-rateB.High aggregate demand,high inflation,low u-rat
8、eYPSRASAD1AD2Y1103A105Y2B6%3%A4%5%B 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF7The Phillips Curve:A Policy Menu?Since fiscal and monetary policy affect aggregate demand,the Phillips curve(PC)appeared to offer policymakers a me
9、nu of choices:low unemployment with high inflationlow inflation with high unemploymentanything in between1960s:U.S.data supported the Phillips curve.Many believed the PC was stable&reliable.2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRA
10、DE-OFF8Evidence for the Phillips Curve?Inflation rate(%per year)Unemployment rate(%)During the 1960s,U.S.policymakers opted for reducing unemployment at the expense of higher inflation196163656264666768 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN IN
11、F.&U-RATE TRADE-OFF9(2)Shifts in Phillips Curve:Role of Expectations 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF10(A)The Vertical Long-Run Phillips Curve1968:Milton Friedman and Edmund Phelps argued that the tradeoff was tempor
12、ary.Natural-rate hypothesis:the claim that unemployment eventually returns to its normal or“natural”rate,regardless of the inflation rateBased on the classical dichotomy and the vertical LRAS curveThe Vertical Long-Run Phillips Curveu-rateinflationIn the long run,faster money growth only causes fast
13、er inflation.YPLRASAD1AD2Natural rate of outputNatural rate of unemploymentP1P2LRPClow infla-tionhigh infla-tion11 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF12(B)Reconciling Theory and EvidenceEvidence(from 60s):PC slopes down
14、ward.Theory(Friedman and Phelps):PC is vertical in the long run.To bridge the gap between theory and evidence,Friedman and Phelps introduced a new variable:expected inflation a measure of how much people expect the price level to change.2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.E
15、CON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF13(C)The Phillips Curve EquationShort run The Central Bank can reduce u-rate below the natural u-rate by making inflation greater than expected.(Note that b 0.)Long run Expectations catch up to reality(when expected inflation=actual inflation),u-r
16、ate goes back to natural u-rate whether inflation is high or low.Unemp.rateNatural rate of unemp.=bActual inflationExpected inflation 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF14(D)How Expected Inflation Shifts the PCInitially
17、,expected&actual inflation=3%,unemployment=natural rate(6%).Central Bank makes inflation 2%higher than expected,u-rate falls to 4%.In the long run,expected inflation increases to 5%,PC shifts upward,unemployment returns to its natural rate.u-rateinflationPC1LRPC6%3%PC24%5%ABCNatural rate of unemploy
18、ment=5%Expected inflation=2%In PC equation,b=0.5A.Plot the long-run Phillips curve.B.Find the u-rate for each of these values of actual inflation:0%,6%.Sketch the short-run PC.C.Suppose expected inflation rises to 4%.Repeat part B.D.Instead,suppose the natural rate falls to 4%.Draw the new long-run
19、Phillips curve,then repeat part B.151601234567012345678unemployment rateinflation rateLRPCAAn increase in expected inflation shifts PC to the right.PCDLRPCDPCBPCCA fall in the natural rate shifts both curves to the left.2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)C
20、h 22:SHORT-RUN INF.&U-RATE TRADE-OFF17(E)The Breakdown of the Phillips CurveInflation rate(%per year)Unemployment rate(%)Early 1970s:unemployment increased,despite higher inflation.Friedman&Phelps explanation:expectations were catching up with reality.1961636562646667686970717273 2009 South-Western
21、Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF18(3)Shifts in Phillips Curve:Role of Supply Shocks 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF19Another PC Shifter:Supply ShocksS
22、upply shock:an event that directly alters firms costs and prices,shifting the AS and PC curves Example:large increase in oil prices 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF20How an Adverse Supply Shock Shifts the PCu-rateinf
23、lationSRAS shifts left,prices rise,output&employment fall.Inflation&u-rate both increase as the PC shifts upward.YPSRAS1ADPC1PC2ABSRAS2AY1P1Y2BP2 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF21The 1970s Oil Price ShocksThe Fed(U.
24、S.Central Bank)chose to accommodate the first shock in 1973 with faster money growth.Result:Higher expected inflation,which further shifted PC.1979:Oil prices surged again,worsening the Feds tradeoff.38.001/198132.501/198014.851/197910.111/1974$3.561/1973Oil price per barrel 2009 South-Western Princ
25、iples of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF22The 1970s Oil Price ShocksInflation rate(%per year)Unemployment rate(%)Supply shocks&rising expected inflation worsened the PC tradeoff.1972737475767778798081 2009 South-Western Principles of Macroeconomics
26、,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF23(4)The Cost of Reducing Inflation 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF24The Cost of Reducing InflationDisinflation:a reduction in the inflation rate
27、To reduce inflation,the Fed(U.S.Central Bank)must slow the rate of money growth,which reduces aggregate demand.Short run:Output falls and unemployment rises.Long run:Output&unemployment return to their natural rates.2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22
28、:SHORT-RUN INF.&U-RATE TRADE-OFF25(A)Disinflationary Monetary PolicyContractionary monetary policy moves economy from A to B.Over time,expected inflation falls,PC shifts downward.In the long run,point C:the natural rate of unemployment,&lower inflation.u-rateinflationLRPCPC1natural rate of unemploym
29、entAPC2CB 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF26(B)Sacrifice RatioDisinflation requires enduring a period of high unemployment and low output.Sacrifice ratio:percentage points of annual output lost(over the years)per 1 p
30、ercentage point reduction in inflationTypical estimate of the sacrifice ratio:5To reduce inflation rate 1%,must sacrifice 5%of a years output.Can spread cost over time,e.g.To reduce inflation by 6%,can eithersacrifice 30%of GDP for one yearsacrifice 10%of GDP for three years 2009 South-Western Princ
31、iples of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF27(C)Rational Expectations,Costless Disinflation?Rational expectations:a theory according to which people optimally use all the information they have,including information about government policies,when forec
32、asting the future Early proponents:Robert Lucas,Thomas Sargent,Robert BarroImplied that disinflation could be much less costly 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF28Rational Expectations,Costless Disinflation?Suppose the
33、 Central Bank convinces everyone it is committed to reducing inflation.Then,expected inflation falls,the short-run PC shifts downward quickly.Result:Disinflations can cause less unemployment than the traditional sacrifice ratio predicts.In the extreme case,it could be close to zero,when people adjus
34、t inflation expectation immediately.2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF29(D)The Volcker DisinflationFed Chairman Paul VolckerAppointed in late 1979 under high inflation&unemploymentChanged Fed policy to disinflation1981
35、-1984:Fiscal policy was expansionary,so Fed policy had to be very contractionary to reduce inflation.Success:Inflation fell from 10%to 4%,but at the cost of high unemployment 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF30The Vol
36、cker DisinflationInflation rate(%per year)Unemployment rate(%)Disinflation turned out to be very costlyu-rate near 10%in 1982-8319798081828384858687 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF31(E)The Greenspan Era1986:Oil pric
37、es fell 50%.1989-90:Unemployment fell,inflation rose.Fed raised interest rates,caused a mild recession.1990s:Unemployment and inflation fell.2001:Negative demand shocks created the first recession in a decade.Policymakers responded with expansionary monetary and fiscal policy.Alan Greenspan Chair of
38、 FOMC,Aug 1987 Jan 2006 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF32The Greenspan EraInflation rate(%per year)Unemployment rate(%)Inflation and unemployment were low during most of Alan Greenspans years as Fed Chairman.1987909
39、22000949698060205 2009 South-Western Principles of Macroeconomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF33(F)Ben Bernankes challengesAggregate demand shocks:Subprime mortgage crisis,falling housing prices,widespread foreclosures,financial sector troubles.Aggregate suppl
40、y shocks:Rising prices of food/agricultural commodities,e.g.,Corn per bushel:$2.10 in 2005-06,$5.76 in 5/2008Rising oil pricesOil per barrel:$35 in 2/2004,$134 in 6/2008From 6/2007 to 6/2008,unemployment rose from 4.6%to 5.5%CPI inflation rose from 2.6%to 4.9%2009 South-Western Principles of Macroec
41、onomics,by N.G.Mankiw.ECON1002C/D(2011)Ch 22:SHORT-RUN INF.&U-RATE TRADE-OFF34CONCLUSIONThe theories in this chapter come from some of the greatest economists of the 20th century.They teach us that inflation and unemployment areunrelated in the long runnegatively related in the short runaffected by
42、expectations,which play an important role in the economys adjustment from the short-run to the long run.The Phillips curve describes the short-run tradeoff between inflation and unemployment.In the long run,there is no tradeoff:inflation is determined by money growth,while unemployment equals its na
43、tural rate.Supply shocks and changes in expected inflation shift the short-run Phillips curve,making the tradeoff more or less favorable.35The Central Bank can reduce inflation by contracting the money supply,which moves the economy along its short-run Phillips curve and raises unemployment.In the long run,though,expectations adjust and unemployment returns to its natural rate.Some economists argue that a credible commitment to reducing inflation can lower the costs of disinflation by inducing a rapid adjustment of expectations.36
