Chapter 12: Unemployment and Inflation

Learning Objectives

• Describe the Phillips curve relationship between unemployment and inflation.

• Discuss whether the Phillips curve offers a 'menu' of inflation-unemployment combinations for policymakers.

• Identify the costs of unemployment and discuss the natural rate of unemployment.

• Discuss the types and costs of inflation.

• Discuss the challenges and costs of reducing inflation, including the role of inflationary expectations.

Unemployment and Inflation: Is There a Trade-off?

The Phillips Curve: Historical Perspective

The Phillips curve illustrates the relationship between unemployment and inflation. In 1958, A.W. Phillips identified a negative relationship between unemployment and nominal wage growth in Britain, which was later extended to the relationship between unemployment and inflation.

• In the 1950s and 1960s, many countries, including the United States, observed a negative correlation between unemployment and inflation.

• This suggested that policymakers could potentially choose their preferred combination of unemployment and inflation.

Example: Figure 12.1 shows the Phillips curve for the U.S. economy during the 1960s, with lower unemployment associated with higher inflation rates.

Breakdown of the Phillips Curve Relationship

In the 1970s and subsequent decades, the previously observed relationship between unemployment and inflation broke down.

• Both high inflation and high unemployment occurred simultaneously, a phenomenon known as stagflation.

• Figure 12.2 demonstrates the lack of a clear trade-off between inflation and unemployment in the United States from 1970 to 2021.

The Expectations-Augmented Phillips Curve

Economists such as Friedman and Phelps argued that the relationship between unemployment and inflation depends on expectations. The expectations-augmented Phillips curve incorporates the role of anticipated and unanticipated inflation.

• Cyclical unemployment (the difference between actual and natural unemployment rates) is affected only by unanticipated inflation.

• When inflation is anticipated, unemployment remains at its natural rate.

Formula:

• Where is actual inflation, is expected inflation, is actual unemployment, and is the natural rate of unemployment.

Short-Run and Long-Run Phillips Curves

• The short-run Phillips curve shows the trade-off between cyclical unemployment and actual inflation for a given expected rate of inflation and natural rate of unemployment.

• Changes in expected inflation or the natural rate of unemployment shift the short-run Phillips curve.

• The long-run Phillips curve is vertical at the natural rate of unemployment, indicating no long-run trade-off between inflation and unemployment.

Supply Shocks and Instability

• Adverse supply shocks (e.g., oil price increases) can raise both expected inflation and the natural rate of unemployment, shifting the Phillips curve upward and to the right.

• Periods with frequent supply shocks result in an unstable Phillips curve.

Macroeconomic Policy and the Phillips Curve

Policy Implications

• In the classical model, the unemployment rate quickly returns to its natural level as expectations adjust, so policymakers cannot systematically exploit the Phillips curve.

• In the Keynesian model, unemployment may differ from the natural rate temporarily due to sticky prices and wages, allowing short-term policy effects.

The Lucas Critique

The Lucas critique argues that historical relationships between economic variables may not hold after major policy changes, as people's behavior adapts to new rules.

• Evaluating policy requires understanding how behavior will change under new policies, using both theory and empirical analysis.

Long-Run Phillips Curve

• In the long run, unemployment returns to the natural rate (), and the Phillips curve is vertical.

• Monetary policy can only affect unemployment temporarily; long-run effects are neutral.

The Problem of Unemployment

Costs of Unemployment

• Loss of output from idle resources.

• Workers lose income; society pays for unemployment benefits and loses tax revenue.

• Okun's Law: Each percentage point of cyclical unemployment is associated with a loss equal to 2% of full-employment output.

Formula:

• If full-employment output is , then a 1% increase in unemployment costs .

Example: If trillion, each percentage point of unemployment costs $400$ billion per year.

Personal and Social Costs

• Unemployment causes psychological distress, especially for long-term unemployed.

• Long-term unemployment reduces future job prospects and earnings.

• Costs vary across demographic groups and are worse during severe recessions.

Offsetting Factors

• Unemployment can lead to increased job search and skill acquisition, potentially raising future output.

• Unemployed workers have more leisure time, though this rarely compensates for lost income.

The Natural Rate of Unemployment

• The natural rate of unemployment is the rate consistent with stable inflation, estimated at about 4.5% in 2021 by the CBO.

• Demographic changes, such as a declining proportion of young workers, have reduced the natural rate over time.

• Measuring the natural rate is difficult; estimates are imprecise and subject to revision.

The Problem of Inflation

Types and Costs of Inflation

• Perfectly anticipated inflation: Minimal effects if all prices and wages adjust; costs include shoe-leather costs (resources spent economizing on cash) and menu costs (costs of changing prices).

• Unanticipated inflation: Real returns differ from expected returns, causing wealth transfers between lenders and borrowers.

Formula:

• Expected real return:

• Actual real return:

Indexed Contracts

• Indexed contracts (e.g., COLAs, inflation-indexed bonds) can reduce the risk of unanticipated inflation.

• More common in countries with high inflation.

Loss of Price Signals

• Inflation can obscure changes in relative prices, making it harder for markets to allocate resources efficiently.

Hyperinflation

• Hyperinflation is extremely high, sustained inflation (e.g., 50% per month).

• Examples: Hungary (1945), Zimbabwe (2006-2008).

• Hyperinflation leads to severe economic disruption, loss of price signals, and collapse of tax revenues.

Can Inflation Be Too Low?

• Low inflation or deflation can be harmful, as seen in the 1930s.

• Deflation increases real wages if nominal wages are sticky, reducing employment.

• Central banks may be unable to reduce real interest rates sufficiently during deflation.

• Most central banks target inflation around 2% to minimize risks of both high inflation and deflation.

Fighting Inflation: The Role of Inflationary Expectations

Causes of Rapid Money Growth

• Developing or war-torn countries may print money to finance spending.

• Industrialized countries may use expansionary monetary policy during recessions and fail to tighten policy later.

Disinflation Strategies

• Disinflation is a reduction in the rate of inflation.

• Rapid ("cold turkey") disinflation involves a decisive reduction in money growth; proponents argue for quick adjustment if policy is credible.

• Keynesians advocate gradual disinflation to allow prices and wages to adjust, minimizing recession risk.

The Sacrifice Ratio

• The sacrifice ratio measures the percentage of output lost to reduce inflation by one percentage point.

• Example: In the U.S. early 1980s, inflation fell by 8.83 points with a 16.18% output loss; sacrifice ratio = .

• Higher labor market flexibility leads to lower sacrifice ratios.

Wage and Price Controls

• Controls can temporarily reduce inflation and expectations but often lead to shortages and inefficiency.

• Once controls are lifted, prices typically rise to previous levels.

Credibility and Reputation

• Successful disinflation depends on the credibility of policy; if people believe the government will maintain low inflation, expectations adjust quickly.

• Independent central banks enhance credibility.

U.S. Disinflation in the 1980s and 1990s

• Fed chairmen Volcker and Greenspan gradually reduced inflation, stabilizing expectations.

• The Fed adopted a 2% inflation target in 2012 and later flexible average inflation targeting in 2020.

Key Tables

Table: Phillips Curve Observations (Described)

Table: Costs of Unemployment (Described)

Table: Types of Inflation (Described)

Additional info: Some formulas, tables, and examples have been expanded for clarity and completeness.