Macroeonomics. 22 this chapter, look for the answers to these questions: The Phillips Curve. Introduction. N. Gregory Mankiw

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1 C H P T E R In this chapter, look for the answers to these questions: The Short-Run Trade-off etween How are and unemployment related in the Inflation and Unemployment short run? In the long run? P R I N C I P L E S O F Macroeonomics N. Gregory Mankiw What factors alter this relationship? What is the short-run cost of reducing? Why were U.S. and unemployment both so low in the 199s? Premium PowerPoint Slides by Ron Cronovich 9 South-Western, a part of Cengage Learning, all rights reserved 1 Introduction In the long run, & unemployment are unrelated: The rate depends mainly on growth in the money 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 and unemployment. The Phillips Curve Phillips curve: shows the short-run trade-off between and unemployment 195:.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in the U.K. 19: Paul Samuelson & Robert Solow found a negative correlation between U.S. & unemployment, named it the Phillips Curve. THE SHORT-RUN TRDE-OFF THE SHORT-RUN TRDE-OFF 3 1

2 Deriving the Phillips Curve Suppose P = 1 this year. The following graphs show two possible outcomes for next year:. gg demand low, small increase in P (i.e., low ), low output, high unemployment.. gg demand high, big increase in P (i.e., high ), high output, low unemployment. THE SHORT-RUN TRDE-OFF Deriving the Phillips Curve. Low agg demand, low, high P Y 1 Y SRS D D 1 Y 5% 3% PC % %. High agg demand, high, low THE SHORT-RUN TRDE-OFF 5 The Phillips Curve: Policy Menu? Since fiscal and mon policy affect agg demand, the PC appeared to offer policymakers a menu of choices: low unemployment with high low with high unemployment anything in between 19s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable. THE SHORT-RUN TRDE-OFF Inflation rate Evidence for the Phillips Curve? 1 During the 19s, U.S. policymakers opted for reducing unemployment at the expense of higher Unemployment THE SHORT-RUN TRDE-OFF 7

3 The Vertical Long-Run Phillips Curve 19: Milton Friedman and Edmund Phelps argued that the tradeoff was temporary. Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or natural rate, regardless of the rate ased on the classical dichotomy and the vertical LRS curve THE SHORT-RUN TRDE-OFF P P 1 The Vertical Long-Run Phillips Curve P In the long run, faster money growth only causes faster. LRS Natural rate of output D 1 D Y high low LRPC Natural rate of unemployment 9 Reconciling Theory and Evidence Evidence (from s): PC slopes downward. 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 a measure of how much people expect the price level to change. Unemp. rate The Phillips Curve Equation Natural = rate of a ctual Expected unemp. Short run Fed can reduce below the natural by making greater than expected. Long run Expectations catch up to reality, goes back to natural whether is high or low. THE SHORT-RUN TRDE-OFF 1 THE SHORT-RUN TRDE-OFF 11 3

4 How Expected Inflation Shifts the PC Initially, expected & actual = 3%, unemployment = natural. Fed makes % higher than expected, falls to %. In the long run, expected increases to 5%, PC shifts upward, unemployment returns to its natural rate. 5% 3% % LRPC % PC 1 PC THE SHORT-RUN TRDE-OFF 1 C C T I V E L E R N I N G 1 numerical example Natural rate of unemployment = 5% Expected = % In PC equation, a =.5. Plot the long-run Phillips curve.. Find the for each of these values of actual : %, %. Sketch the short-run PC. C. Suppose expected rises to %. Repeat part. D. Instead, suppose the natural rate falls to %. Draw the new long-run Phillips curve, then repeat part. 13 C T I V E L E R N I N G 1 nswers n increase in expected shifts PC to the right. fall in the natural rate shifts both curves to the left. rate PC PC D LRPC D LRPC unemployment rate PC C 1 The reakdown of the Phillips Curve Inflation rate 1 Early 197s: unemployment increased, despite higher. Friedman & Phelps explanation: expectations 73 expectations were catching 7 up with reality Unemployment THE SHORT-RUN TRDE-OFF 15

5 nother PC Shifter: Supply Shocks Supply shock: an event that directly alters firms costs and prices, shifting the S and PC curves Example: large increase in oil prices How an dverse Supply Shock Shifts the PC SRS shifts left, prices rise, output & employment fall. P SRS P P 1 SRS 1 PC D PC 1 Y Y 1 Y THE SHORT-RUN TRDE-OFF 1 Inflation & both increase as the PC shifts upward. THE SHORT-RUN TRDE-OFF 17 1/1973 1/197 1/1979 1/19 1/191 The 197s Oil Price Shocks Oil price per barrel $ The Fed chose to accommodate the first shock in 1973 with faster money growth. Result: Higher expected, which further shifted PC. 1979: Oil prices surged again, worsening the Fed s tradeoff. THE SHORT-RUN TRDE-OFF 1 Inflation rate 1 The 197s Oil Price Shocks Supply shocks & rising expected worsened the PC tradeoff. 1 Unemployment THE SHORT-RUN TRDE-OFF

6 The Cost of Reducing Inflation Dis: a reduction in the rate To reduce, Fed must slow the rate of money growth, which reduces agg demand. Short run: Output falls and unemployment rises. Long run: Output & unemployment return to their natural rates. THE SHORT-RUN TRDE-OFF Disary Monetary Policy Contractionary monetary policy moves economy from to. Over time, expected falls, PC shifts downward. In the long run, point C: the natural rate of unemployment, lower. LRPC PC 1 natural rate of unemployment THE SHORT-RUN TRDE-OFF 1 C PC The Cost of Reducing Inflation Dis requires enduring a period of high unemployment and low output. Sacrifice ratio: percentage points of annual output lost per 1 percentage point reduction in Typical estimate of the sacrifice ratio: 5 To reduce rate 1%, must sacrifice 5% of a year s output. Can spread cost over time, e.g. To reduce by %, can either sacrifice 3% of GDP for one year sacrifice 1% of GDP for three years THE SHORT-RUN TRDE-OFF Rational Expectations, Costless Dis? Rational expectations: a theory according to which people optimally use all the information they have, including info about govt policies, when forecasting the future Early proponents: Robert Lucas, Thomas Sargent, Robert arro Implied that dis could be much less costly THE SHORT-RUN TRDE-OFF 3

7 Rational Expectations, Costless Dis? Suppose the Fed convinces everyone it is committed to reducing. Then, expected falls, the short-run PC shifts downward. Result: Diss can cause less unemployment than the traditional sacrifice ratio predicts. The Volcker Dis Fed Chairman Paul Volcker ppointed in late 1979 under high & unemployment Changed Fed policy to dis : Fiscal policy was expansionary, so Fed policy had to be very contractionary to reduce. Success: Inflation fell from 1% to %, but at the cost of high unemployment THE SHORT-RUN TRDE-OFF THE SHORT-RUN TRDE-OFF 5 Inflation rate 1 The Volcker Dis Dis turned out to be very costly near 1% in Unemployment THE SHORT-RUN TRDE-OFF The Greenspan Era 19: Oil prices fell 5% : Unemployment fell, rose. Fed raised interest rates, caused a mild recession. 199s: Unemployment and fell. lan Greenspan Chair of FOMC, ug 197 Jan 1: Negative demand shocks created the first recession in a decade. Policymakers responded with expansionary monetary and fiscal policy. THE SHORT-RUN TRDE-OFF 7 7

8 Inflation rate 1 The Greenspan Era Inflation and unemployment were low during most of lan Greenspan s years as Fed Chairman Unemployment THE SHORT-RUN TRDE-OFF en ernanke s challenges ggregate demand shocks: Subprime mortgage crisis, falling housing prices, widespread foreclosures, financial sector troubles. ggregate supply shocks: Rising prices of food/agricultural commodities, e.g., Corn per bushel: $.1 in 5-, $5.7 in 5/ Rising oil prices Oil per barrel: $35 in /, $13 in / From /7 to /9, unemployment rose from.% to 9.5% CPI fell from.% to -1% THE SHORT-RUN TRDE-OFF 9 CONCLUSION The theories in this chapter come from some of the greatest economists of the th century. They teach us that and unemployment are unrelated in the long run negatively related in the short run affected by expectations, which play an important role in the economy s adjustment from the short-run to the long run. CHPTER SUMMRY The Phillips curve describes the short-run tradeoff between and unemployment. In the long run, there is no tradeoff: is determined by money growth, while unemployment equals its natural rate. Supply shocks and changes in expected shift the short-run Phillips curve, making the tradeoff more or less favorable. THE SHORT-RUN TRDE-OFF 3 31

9 CHPTER SUMMRY The Fed can reduce 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 can lower the costs of dis by inducing a rapid adjustment of expectations. 3 9