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LICENSED TO:

THE TRADE-OFF BETWEEN INFLATION

AND UNEMPLOYMENT

We must seek to reduce inflation at a lower cost in lost output and unemployment.

JIMMY CARTER

I magine that you were Ben Bernanke, Chairman of the Federal Reserve Board, cutting interest rates in 2007 and 2008 in order to boost aggregate demand. Two things you would have liked to know is how much your actions were likely to speed up real GDP growth, and hence reduce unemployment, and how much they were likely to increase inflation—because monetary policy normally moves unemployment and

inflation in opposite directions in the short run.

This is an idea we first encountered in our list of Ideas for Beyond the Final Exam in Chapter 1. Back then, we noted that there is a bothersome trade-off between inflation and unemployment: High-growth policies that reduce unemployment tend to raise inflation, and slow-growth policies that reduce inflation tend to raise unemployment. We subsequently observed, in Chapter 14, that the trade-off looks rather different in the short run than in the long run because the aggregate supply curve is fairly flat in the short run but quite steep (or vertical) in the long run. A statistical relationship called the Phillips curve seeks to summarize the quantitative dimensions of the trade-off between inflation and unemployment in both the short and long runs. This chapter is about the Phillips curve; that is, it is about one of the things that Chairman Bernanke was wondering in 2007 and 2008.

C O N T E N T S

ISSUE: IS THE TRADE-OFF BETWEEN INFLATION	WHAT THE PHILLIPS CURVE IS NOT	THE THEORY OF RATIONAL EXPECTATIONS
AND UNEMPLOYMENT A RELIC OF THE PAST?	FIGHTING UNEMPLOYMENT WITH FISCAL	What Are Rational Expectations?
	FIGHTING UNEMPLOYMENT WITH FISCAL	Rational Expectations and the Trade-Off
DEMAND-SIDE INFLATION VERSUS	AND MONETARY POLICY	Rational Expectations and the Trade-Off
SUPPLY-SIDE INFLATION: A REVIEW	WHAT SHOULD BE DONE?	An Evaluation
	WHAT SHOULD BE DONE?	WHY ECONOMISTS (AND POLITICIANS)
ORIGINS OF THE PHILLIPS CURVE	The Costs of Inflation and Unemployment	WHY ECONOMISTS (AND POLITICIANS)
SUPPLY-SIDE INFLATION AND THE	The Slope of the Short-Run Phillips Curve	DISAGREE
SUPPLY-SIDE INFLATION AND THE	The Slope of the Short-Run Phillips Curve	THE DILEMMA OF DEMAND MANAGEMENT
COLLAPSE OF THE PHILLIPS CURVE	The Efficiency of the Economy’s Self-Correcting	THE DILEMMA OF DEMAND MANAGEMENT
Explaining the Fabulous 1990s	Mechanism	ATTEMPTS TO REDUCE THE NATURAL RATE
Explaining the Fabulous 1990s		ATTEMPTS TO REDUCE THE NATURAL RATE
ISSUE RESOLVED: WHY INFLATION AND	INFLATIONARY EXPECTATIONS AND THE	OF UNEMPLOYMENT
UNEMPLOYMENT BOTH DECLINED	PHILLIPS CURVE	INDEXING
		INDEXING

LICENSED TO:
318	PART 3 Fiscal and Monetary Policy

		ISSUE:	IS THE TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

A RELIC OF THE PAST?

In the late 1990s, unemployment in the United States fell to extremely low levels—the lowest in 30 years. Yet, in stark contrast to prior experience, inflation did not rise. In fact, it fell slightly. This pleasant conjunction of events, which was nearly unprecedented in U.S. history, set many people talking about a glorious “New Economy” in which there was no longer any trade-off

between inflation and unemployment. The soaring stock market, especially for technology stocks, added to the euphoria.

Is the long-feared trade-off really just a memory now? Can the modern economy speed along without fear of rising inflation? Or does faster growth eventually have inflationary consequences? These are questions the Federal Reserve wrestled with in 2007 and 2008, and they are the central questions for this chapter. Our answers, in brief, are: no, no, and yes. And we will devote most of this chapter to explaining why.

DEMAND-SIDE INFLATION VERSUS SUPPLY-SIDE INFLATION: A REVIEW

FIGURE 1

Inflation from the Demand Side

Price Level

Demand-side inflation is a rise in the price level caused by rapid growth of aggregate demand.

Supply-side inflation is a rise in the price level caused by slow growth (or decline) of aggregate supply.

We begin by reviewing some of what we learned about inflation in earlier chapters. One major cause of inflation, although certainly not the only one, is rapid growth of aggregate demand. We know that any autonomous increase in spending—whether initiated by consumers, investors, the government, or foreigners—has multiplier effects on aggregate demand. So each additional $1 of C or I or G or (X 2 IM) leads to more than $1 of addi-

tional demand. We also know that firms normally find it profitable to supply additional output only at higher prices; that is, the aggregate supply curve slopes upward. Hence, a stimulus to aggregate demand normally pulls up both real output and prices.

Figure 1, which is familiar from earlier chapters, reviews

Sthis conclusion. Initially, the economy is at point A, where aggregate demand curve D0D0 intersects aggregate supply

			curve SS. Then something happens to increase spending,
B			and the aggregate demand curve shifts horizontally to D1D1.
			The new equilibrium is at point B, where both prices and
			output are higher than they were at A. Thus, the economy
			experiences both inflation and increased output. The slope
			of the aggregate supply curve measures the amount of infla-
		D1	tion that accompanies any specified rise in output and there-

			fore calibrates the trade-off between inflation and economic

	D0		growth.
	D0		But we also have learned in this book (especially in
			But we also have learned in this book (especially in
Real GDP			Chapter 10) that inflation does not always originate from the

			demand side. Anything that retards the growth of aggregate
			supply—for example, an increase in the price of foreign oil—

can shift the economy’s aggregate supply curve inward. This sort of inflation is illustrated in Figure 2, where the aggregate supply curve shifts inward from S0S0 to S1S1, and the economy’s equilibrium consequently moves from point A to point B. Prices rise as output falls. We have stagflation.

Thus, although inflation can emanate from either the demand side or the supply side of the economy, a crucial difference arises between the two sources. Demand-side inflation is normally accompanied by rapid growth of real GDP (as in Figure 1), whereas supply-side inflation is normally accompanied by stagnant or even falling GDP (as in Figure 2). This distinction has major practical importance, as we will see in this chapter.

LICENSED TO:

CHAPTER 16 The Trade-Off between Inflation and Unemployment 319

ORIGINS OF THE PHILLIPS CURVE					S1
ORIGINS OF THE PHILLIPS CURVE

Let us begin by supposing that most economic fluctua-		D0
Let us begin by supposing that most economic fluctua-						S0
tions are driven by gyrations in aggregate demand. In
tions are driven by gyrations in aggregate demand. In
that case, we have just seen that GDP growth and in-
flation should rise and fall together. Is this what the data	Level
show?			B
We will see shortly, but first let us translate the prediction
	Price
into a corresponding statement about the relationship be-				A
into a corresponding statement about the relationship be-
tween inflation and unemployment. Faster growth of real out-
		S1
put naturally means faster growth in the number of jobs and,		S1

hence, lower unemployment. Conversely, slower growth of		S0
real output means slower growth in the number of jobs and,		S0
real output means slower growth in the number of jobs and,
hence, higher unemployment. So we conclude that if business					D0
fluctuations emanate from the demand side, unemployment					D0

				Real GDP
and inflation should move in opposite directions. Unemploy-				Real GDP
ment should fall when inflation rises high and rise when

inflation falls.

FIGURE 2

Figure 3 illustrates the idea. The unemployment rate in the United States in 2007

Inflation from the

averaged 4.6 percent (which we approximate by 5 percent in the figure), and the

Supply Side

Consumer Price Index was 2.8 percent higher than in 2006 (which we approximate by

2 percent). Point B in Figure 3 records these two numbers. Had aggregate demand

FIGURE 3

grown faster, inflation would have been higher and unemployment would have been

lower. To create a concrete example, let us suppose that

Origins of the Phillips

unemployment would have been 4 percent and inflation

Curve

would have been 3 percent—as shown by point A in Fig-

ure 3. By contrast, had aggregate demand grown more

slowly than it actually did, unemployment would have

been higher and inflation lower. In Figure 3, we suppose

that unemployment would have been 6 percent and in-

flation would have been just 1 percent (point C). This

Rate

figure displays the principal empirical implication of

our theoretical model:

Inflation

If fluctuations in economic activity are caused primarily

by variations in the rate at which the aggregate demand

curve shifts outward from year to year, then the data

should show an inverse relationship between unem-

ployment and inflation.

Now we are ready to look at real data. Do we actually

observe such an inverse relationship between inflation

Unemployment

Rate

and unemployment? About 50 years ago, the economist

A. W. Phillips plotted data on unemployment and the

rate of change of money wages (not prices) for several extended periods of British his-

tory on a series of scatter diagrams, one of which is reproduced on the next page as Fig-

A Phillips curve is a graph

ure 4. He then sketched a curve that seemed to fit the data well. This type of curve,

depicting the rate of unem-

which we now call a Phillips curve, shows that wage inflation normally is high when

ployment on the horizontal

unemployment is low and is low when unemployment is high. So far, so good. These

axis and either the rate of

data illustrate the short-run trade-off between inflation and unemployment, one of our

inflation or the rate of

Ideas for Beyond the Final Exam.

change of money wages on

Phillips curves are more commonly constructed for price inflation; Figure 5 on the next

the vertical axis. Phillips

curves are normally

page shows a Phillips-type diagram for the post–World War II United States. This curve

downward-sloping, indicat-

also appears to fit the data well. As viewed through the eyes of our theory, these facts sug-

ing that higher inflation

gest that economic fluctuations in Great Britain between 1861 and 1913 and in the United

rates are associated with

States between 1954 and 1969 probably arose primarily from changes in the growth rate of

lower unemployment rates.

LICENSED TO:

320

PART 3

Fiscal and Monetary Policy

FIGURE 4

The Original Phillips Curve

	Rates	10
	Rates	8
	WageMoneyofChange YearperPercentin	8
	WageMoneyofChange YearperPercentin	6
		4
		2
		0
	of	–2
	of
	Rate	–4
		–4

Unemployment Rate in Percent

Series, 25 (November 1958).

Change of Money Wages in the United Kingdom, 1861–1957,” Economica, New

SOURCE: A. W. Phillips, “The Relation between Unemployment and the Rate of

FIGURE 5

A Phillips Curve for the United States, 1954–1969

Inflation Rate

1968

1969

1966

1956	1955
1956	1965
1957	1965	1954
1957		1954
		1962
1967	1964	1959	1958
	1964		1961
	1960		1961
	1960
		1963

0	1	2	3	4	5	6	7	8	9	10
				Unemployment Rate in Percent

aggregate demand. The simple model of demand-side inflation really does seem to describe what happened.

During the 1960s and early 1970s, many economists thought of the Phillips curve as a “menu” of choices available to policy makers. In this view, policy makers could opt for low unemployment and high inflation—as in 1969—or for high unemployment and low inflation—as in 1961. The Phillips curve was thought to measure the quantitative tradeoff between inflation and unemployment. And for a number of years it seemed to work.

Then something happened. The economy in the 1970s and early 1980s behaved far worse than the historical Phillips curve had led economists to expect. In particular, given the unemployment rates in each of those years, inflation was astonishingly high by past standards. This fact is shown clearly by Figure 6, which simply adds to Figure 5 the data points for 1970 to 1984. So something went badly wrong with the old view of the Phillips curve as a menu for policy choices. But what? There are two major answers to this question, and a full explanation contains elements of each.

LICENSED TO:

CHAPTER 16 The Trade-Off between Inflation and Unemployment 321

SUPPLY-SIDE INFLATION AND THE COLLAPSE OF THE PHILLIPS CURVE

We begin with the simpler answer, which is that much
of the inflation in the years from 1972 to 1982 did not		12%
of the inflation in the years from 1972 to 1982 did not		12%
emanate from the demand side at all. Instead, the
emanate from the demand side at all. Instead, the		11
1970s and early 1980s were full of adverse “supply


shocks”—events such as crop failures in 1972–1973		10							1974
shocks”—events such as crop failures in 1972–1973		10
and oil price increases in 1973–1974 and again in		9									1980
1979–1980. These events pushed the economy’s aggre-									1979


gate supply curve inward to the left, as was shown in												1981
												1981
	Rate	8						1973		1978				1975
Figure 2 (page 319). What kind of “Phillips curve” will		8												1975

		7											1977
be generated when economic fluctuations come from


the supply side?	Inflation	6				1968				1971
the supply side?		6								1971
Figure 2 reminds us that output will decline (or at					1969			1972				1976
Figure 2 reminds us that output will decline (or at		5			1969			1970				1976
least grow more slowly) and prices will rise when the																	1982




economy is hit by an adverse supply shock. Now, in a		4			1966			1955				1984
economy is hit by an adverse supply shock. Now, in a		4			1966							1984
growing population with more people looking for jobs					1956
		3			1956			1965								1983


each year, a stagnant economy that does not generate					1957			1954
each year, a stagnant economy that does not generate					1957					1962
enough new jobs will suffer a rise in unemployment.					1967					1962
		2								1959			1958
		2								1959			1958
Thus inflation and unemployment will rise together:						1964						1961
Thus inflation and unemployment will rise together:		1					1960


							1963
If fluctuations in economic activity emanate from							1963
If fluctuations in economic activity emanate from
the supply side, higher rates of inflation will be as-
the supply side, higher rates of inflation will be as-		0	1	2	3	4	5			6		7	8		9		10
sociated with higher rates of unemployment, and
lower rates of inflation will be associated with lower					Unemployment Rate in Percent
lower rates of inflation will be associated with lower
rates of unemployment.
rates of unemployment.

FIGURE 6

The major supply shocks of the 1970s stand out clearly in Figure 6. (Remember—these

are real data, not textbook examples.) Food prices soared from 1972 to 1974, and again in A Phillips Curve for the United States?

1978. Energy prices skyrocketed in 1973–1974, and again in 1979–1980. Clearly, the inflation and unemployment data generated by the U.S. economy in 1972–1974 and in 1978–1980 are consistent with our model of supply-side inflation. Most economists believe that supply shocks, not demand shocks, dominated the decade from 1972 to 1982.

Explaining the Fabulous 1990s

Now let’s stand this analysis of supply shocks on its head. Suppose the economy experiences

a favorable supply shock, rather than an adverse one, so that the aggregate supply curve shifts				FIGURE 7

outward at an unusually rapid rate. Any number of factors—such as a drop in oil prices,				The Effects of a
bountiful harvests, or exceptionally rapid techno-				Favorable Supply Shock
				Favorable Supply Shock

logical advance—can have this effect.
logical advance—can have this effect.			S0	Nor mal growth
Whatever the cause, Figure 7 (which dupli-		D1		Nor mal growth
Whatever the cause, Figure 7 (which dupli-		D1		of aggregate supply
cates Figure 14 of Chapter 10) depicts the conse-		D0		S1
quences. The aggregate demand curve shifts		D0		S1
quences. The aggregate demand curve shifts
outward as usual, but the aggregate supply curve
shifts out more than it would in a “normal” year.			C
So the economy’s equilibrium winds up at point	Level	A		Effect of favorable
B rather than at point C, meaning that economic		A	B	Effect of favorable
B rather than at point C, meaning that economic			B	supply shock
growth is faster (B is to the right of C) and infla-	Price			supply shock
growth is faster (B is to the right of C) and infla-
tion is lower (B is below C). Thus, inflation falls
tion is lower (B is below C). Thus, inflation falls
while rapid growth reduces unemployment.
Figure 7 more or less characterizes the experi-
ence of the U.S. economy from 1996 to 1998. Oil		S0		D1
prices plummeted, lowering costs to American		S1	D0
businesses and households. Stunning advances
in technology made computer prices drop even			Real GDP
more rapidly than usual. And the rising value of			Real GDP
more rapidly than usual. And the rising value of

LICENSED TO:

322

PART 3

Fiscal and Monetary Policy

the U.S. dollar made imported goods cheaper to Americans.1 Thus, we benefited from a series of favorable supply shocks, and the effects were as depicted in Figure 7. The U.S. economy grew rapidly, and inflation and unemployment fell together.

ISSUE RESOLVED:

WHY INFLATION AND UNEMPLOYMENT BOTH DECLINED

We now have the answer to the question posed at the start of this chapter. We do not need to add anything new or mysterious to explain the marvelous economic performance of the second half of the 1990s. According to the basic macroeconomic theory taught in this book, favorable supply shocks should produce rapid economic growth with falling inflation—which is just what happened. The U.S. economy did so well, in part, because we were so fortunate.

WHAT THE PHILLIPS CURVE IS NOT

FIGURE 8

The Elimination of a

Recessionary Gap

Price Level

So one view of what went wrong with the Phillips curve is that adverse supply shocks dominated the 1970s and early 1980s. But there is another view, one that holds that policy makers misinterpreted the Phillips curve and tried to pick combinations of inflation and unemployment that were simply unsustainable.

Specifically, we have learned that the Phillips curve is a statistical relationship between inflation and unemployment that we expect to emerge if business cycle fluctuations arise mainly from changes in the growth of aggregate demand. But in the 1970s and 1980s, the curve was widely misinterpreted as depicting a number of alternative equilibrium points from which policy makers could choose.

To understand the flaw in this reasoning, let us quickly review an earlier lesson. We know from Chapter 10 that the economy has a self-correcting mechanism that will cure both inflations and recessions eventually, even if the government does nothing. This idea is important in this context because it tells us that many combinations of output and prices cannot be maintained indefinitely. Some will self-destruct. Specifically, if the economy finds itself far from the normal full-employment level of unemployment, forces will be set in motion that tend to erode the inflationary or recessionary gap.

			Figure 8 depicts the case of a recessionary gap where ag-
			gregate supply curve S0S0 intersects aggregate demand


			curve DD at point A. With equilibrium output well below
	Potential		potential GDP, the economy has unused industrial capacity
	GDP		and unsold output, so inflation will be tame. At the same
		S0	time, the availability of unemployed workers eager for jobs
		S1	limits the rate at which labor can push up wage rates. But
		S1	since wages are the main component of business costs, when
			since wages are the main component of business costs, when
		S2	they decline (relative to what they would have been without
A			a recession) so do costs. These lower costs, in turn, stimulate
	B		greater production. Figure 8 illustrates this process by an
	B		outward shift of the aggregate supply curve—from S0S0 to
			outward shift of the aggregate supply curve—from S0S0 to
		C	the brick-colored curve S1S1.
		C	As the figure shows, the outward shift of the aggregate
			As the figure shows, the outward shift of the aggregate
			supply curve brought on by the recession pushes equilib-
		D	rium output up as the economy moves from point A to
			point B. Thus, the size of the recessionary gap begins to
			shrink. This process continues until the aggregate supply
	Real GDP		shrink. This process continues until the aggregate supply
	Real GDP		curve reaches the position indicated by the blue curve S2S2

1 The dollar and imports will be discussed in detail in Chapter 19.

LICENSED TO:

CHAPTER 16

The Trade-Off between Inflation and Unemployment

323

in Figure 8. Here wages have fallen enough to

eliminate the recessionary gap, and the econ-

omy has reached a full-employment equilib-

rium at point C.2

We can relate this sequence of events to our

discussion of the origins of the Phillips curve

Rate

with the help of Figure 9, which is a hypothetical

Phillips curve. Point a in Figure 9 corresponds to

point A in Figure 8: It shows the initial recession-

Inflation

ary gap with unemployment (assumed to be 6.5

percent) above full employment, which we as-

sume to occur at 5 percent.

But we have just seen that point A in Figure 8—

and therefore also point a in Figure 9—is not

3.5

4.5

5.5

6.5

sustainable. The economy tends to rid itself of

the recessionary gap through the disinflation

Unemployment Rate

in Percent

process just described. The adjustment path from

A to C depicted in Figure 8 would appear on our

FIGURE 9

Phillips curve diagram as a movement toward less inflation and less unemployment—

The Vertical Long-Run

something like the blue arrow from point a to point c in Figure 9.

Phillips Curve

Similarly, points representing inflationary gaps—such as point d in Figure 9—are also not

sustainable. They, too, are gradually eliminated by the self-correcting mechanism that we

studied in Chapter 10. Wages are forced up by the abnormally low unemployment, which

in turn pushes prices higher. Higher prices deter investment spending by forcing up interest

rates, and they deter consumer spending by lowering the purchasing power of consumer

wealth. The inflationary process continues until the amount people want to buy is brought

into line with the amount firms want to sell at normal full employment. During such an ad-

justment period, unemployment and inflation both rise—as indicated by the blue arrow

from point d to point f in Figure 9. Putting these two conclusions together, we see that

On a Phillips curve diagram such as Figure 9, neither points corresponding to an infla-

The economy’s self-

tionary gap (like point d) nor points corresponding to a recessionary gap (like point a)

correcting mechanism

can be maintained indefinitely. Inflationary gaps lead to rising unemployment and ris-

always tends to push the

ing inflation. Recessionary gaps lead to falling inflation and falling unemployment.

unemployment rate back

All the points that are sustainable in the long run (such as c, e, and f), therefore, corre-

toward a specific rate of

unemployment that we call

spond to the same rate of unemployment, which is therefore called the natural rate of

the natural rate of

unemployment. The natural rate corresponds to what we have so far been calling the

unemployment.

“full-employment” unemployment rate.

The vertical (long-run)

Thus, the Phillips curve connecting points d, e, and a is not a menu of policy choices

Phillips curve shows

at all. Although we can move from a point such as e to a point such as d by stimulating

the menu of inflation/

aggregate demand sufficiently, the economy will not be able to remain at d. We cannot

unemployment choices

keep unemployment at such a low level indefinitely. Instead, policy makers must

available to society in the

choose from among points such as c, e, and f, all of which correspond to the same “natu-

long run. It is a vertical

ral” rate of unemployment. For obvious reasons, the line connecting these points has

straight line at the natural

been dubbed the vertical long-run Phillips curve. It is this vertical Phillips curve, connecting points such as e and f, that represents the true long-run menu of policy choices. We thus conclude:

rate of unemployment.

THE TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT In the short run, it is possible to “ride up the Phillips curve” toward lower levels of unemployment by stimulating aggregate demand. (See, for example, point d in Figure 9.) Conversely, by restricting the

IDEAS FOR

growth of demand, it is possible to “ride down the Phillips curve” toward lower rates of BEYOND THE

FINAL EXAM

2 This simple analysis assumes that the aggregate demand curve does not move during the adjustment period. If it is shifting to the right, the recessionary gap will disappear even faster, but inflation will not slow down as much. (Exercise: Construct the diagram for this case by adding a shift of the aggregate demand curve to Figure 8.)

LICENSED TO:

324

PART 3

Fiscal and Monetary Policy

inflation (such as point a in Figure 9). Thus, there is a short run trade-off between unemployment and inflation. Stimulating demand will improve the unemployment picture but worsen inflation; restricting demand will lower inflation but aggravate the unemployment problem.

However, there is no such trade-off in the long run. The economy’s self-correcting mechanism ensures that unemployment will eventually return to the natural rate no matter what happens to aggregate demand. In the long run, faster growth of demand leads only to higher inflation, not to lower unemployment; and slower growth of demand leads only to lower inflation, not to higher unemployment.

FIGHTING UNEMPLOYMENT WITH FISCAL AND MONETARY POLICY

Now let us apply this analysis to a concrete policy problem—one that has often troubled policy makers in the United States and in many other countries. Should the government use its ability to manage aggregate demand through fiscal and monetary policy to combat unemployment? And if so, how? To focus the discussion, we will deal with a recent, realworld example.

The unemployment rate in the United States bottomed out at 3.8 percent in April 2000, a rate that most economists thought was well below the natural rate of unemployment (something like point d in Figure 9). It then began to creep up gradually, and by August 2001 stood at 4.9 percent—which may be close to the natural rate (see point e in the figure). Then the terrorist attacks of September 11, 2001 occurred, and within a few months unemployment had risen to 5.7 percent. By December, the economy was in a position resembling point a in Figure 9, with a recessionary gap.

Even if fiscal and monetary policy makers did nothing, the economy’s self-correcting mechanism would have gradually eroded the recessionary gap. Both unemployment and inflation would have declined gradually as the economy moved along the blue arrow from point a to point c in Figure 9. Eventually, as the diagram shows, the economy would have returned to its natural rate of unemployment (assumed here to be 5 percent) and inflation would have fallen—in the example, from 3 percent to 2 percent.

This eventual outcome is quite satisfactory: Both unemployment and inflation are lower at the end of the adjustment period (point c) than at the beginning (point a). But it may take an agonizingly long time to get there. And American policy makers in 2001 did not view patience as a virtue. Rather than keep hands off, the Federal Reserve started cutting interest rates almost immediately after the terrorist attacks. Fiscal policy reacted as well. Spending on defense and security was increased immediately after the attacks, the first phase of the 2001 tax cut kicked in, and Congress passed a small fiscal stimulus package.

According to the theory we have learned, such a large dose of expansionary fiscal and monetary policy should push the economy up the short-run Phillips curve from a point like a toward a point like e in Figure 9. Compared to simply relying on the self-correcting mechanism, then, the strong policy response presumably led to a faster recovery from the 2001 recession—which was certainly the intent of the president, Congress, and the Fed. But Figure 9 points out that it also probably left us with a higher inflation rate (5 percent in the figure, about 2 percent in reality).

This example illustrates the range of choices open to policy makers. They can wait patiently while the economy’s self-correcting mechanism pulls unemployment down to the natural rate—leading to a long-run equilibrium like point c in Figure 9. Or they can rush the process along with expansionary monetary and fiscal policy—and wind up with the same unemployment rate but higher inflation (point e). In what sense, then, do policy makers face a trade-off between inflation and unemployment? The answer, illustrated by this diagram, is

The cost of reducing unemployment more rapidly by expansionary fiscal and monetary policies is a permanently higher inflation rate.

LICENSED TO:

CHAPTER 16

The Trade-Off between Inflation and Unemployment

325

WHAT SHOULD BE DONE?

Should the government pay the inflationary costs of fighting unemployment? When the transitory benefit (lower unemployment for a while) is balanced against the permanent cost (higher inflation), have we made a good bargain?

We have noted that the U.S. government opted for a strong policy response in 2001. Thus two forces were at work simultaneously: The self-correcting mechanism was pulling the economy toward point c in Figure 9, and expansionary monetary and fiscal policies were pushing it toward point e. The net result was an intermediate path—something like the dotted line leading to point g in Figure 9. As the economy returned to full employment over the years from 2003 to 2006, growth was reasonably strong and inflation rose only a little.

How do policy makers make decisions like this? Our analysis highlights three critical issues on which the answer depends.

The Costs of Inflation and Unemployment

In Chapter 6, we examined the social costs of inflation and unemployment. Many of the benefits of lower unemployment are readily measured in dollars and cents. Basically, we need only estimate how much higher real GDP is each year. However, the costs of the permanently higher inflation rate are more difficult to measure. So there is considerable controversy over the costs and benefits of using demand management to fight unemployment.

Economists and political leaders who believe that inflation is extremely costly may deem it unwise to accept the inflationary consequences of reducing unemployment faster. And indeed, a few dissenters in both 2001 and 2007 (when the Fed once again cut interest rates to stave off recession) were worried about future inflation. Most U.S. policy makers apparently disagreed with that view, however. They decided that reducing unemployment was the higher priority. But things do not always work out that way. In recent decades, European authorities have often avoided expansionary stabilization policies, and allowed unemployment to remain high, rather than accept even slightly higher inflation.

The Slope of the Short-Run Phillips Curve

The shape of the short-run Phillips curve is also critical. Look back at Figure 9, and imagine that the Phillips curve connecting points a, e, and d was much steeper. In that case, the inflationary costs of using expansionary policy to reduce unemployment would be more substantial. By contrast, if the short-run Phillips curve was much flatter than the one shown in Figure 9, unemployment could be reduced with less inflationary cost.

The Efficiency of the Economy’s Self-Correcting Mechanism

We have emphasized that once a recessionary gap opens, the economy’s natural selfcorrecting mechanism will eventually close it—even in the absence of any policy response. The obvious question is: How long must we wait? If the self-correcting mechanism—which works through reductions in wage inflation—is fast and reliable, high unemployment will not last very long. So the costs of waiting will be small. But if wage inflation responds only slowly to unemployment, the costs of waiting may be enormous. That has evidently been true in much of Europe, where unemployment has remained persistently high for years.

The efficacy of the self-correcting mechanism is also surrounded by controversy. Most economists believe that the weight of the evidence points to extremely sluggish wage behavior: Wage inflation appears to respond slowly to economic slack. In terms of Figure 9, this lag means that the economy will traverse the path from a to c at an agonizingly slow pace, so that a long period of weak economic activity will be necessary to bring down inflation.

But a significant minority opinion finds this assessment far too pessimistic. Economists in this group argue that the costs of reducing inflation are not nearly so severe and that

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PART 3

Fiscal and Monetary Policy

Inflation Targeting and the Phillips Curve

In Chapter 14, we mentioned inflation targeting as a new approach to monetary policy that is gaining adherents in many countries. In practice, inflation targeting requires monetary policy makers to rely heavily on the Phillips curve. Why? Because a central bank with, say, a 2 percent inflation target is obligated to pursue a monetary policy that it believes will drive the inflation rate to 2 percent after, say, a year or two. But how does the central bank know which policy will accomplish this goal?

Knowing the proper policy with certainty is, of course, out of the question. But a central bank can use a model similar to the aggregate supply/demand model taught in this book to estimate how its policy choices will affect the unemployment rate, say, this year and next. Then it can use a Phillips curve to estimate how that unemployment path will affect inflation. In fact, that is more or less what inflation-targeting central banks from New Zealand to Norway now do.

the key to a successful anti-inflation policy is how it affects people’s expectations of inflation. To understand this argument, we must first understand why expectations are relevant to the Phillips curve.

INFLATIONARY EXPECTATIONS AND THE PHILLIPS CURVE

Recall from Chapter 10 that the main reason the economy’s aggregate supply curve slopes upward—that is, why output increases as the price level rises—is that businesses typically purchase labor and other inputs under long-term contracts that fix input costs in money terms. (The money wage rate is the clearest example.) As long as such contracts are in force, real wages fall as the prices of goods rise. Labor therefore becomes cheaper in real terms, which persuades businesses to expand employment and output. Buying low and selling high is, after all, the route to higher profits.


TABLE 1					Table 1 illustrates this general idea in a concrete example. We sup-
Money and Real Wages under Unexpected				pose that workers and firms agree today that the money wage to be
Inflation
Inflation				paid a year from now will be $10 per hour. The table then shows the


	Price Level	Wage per	Real Wage	real wage corresponding to each alternative inflation rate. For example,
Inflation	1 Year	Hour 1 Year	per Hour	if inflation is		4 percent, the real wage a year from now will be
Rate	from Now	from Now 1 Year from Now		$10.00/1.04 5		$9.62. Clearly, the higher the inflation rate, the higher the
				$10.00/1.04 5
0%	100	$10.00	$10.00	price level at the end of the year and the lower the real wage.
2	102	10.00	9.80		Lower real wages provide an incentive for firms to increase output,
4	104	10.00	9.62
4	104	10.00	9.62	as we have just noted. But lower real wages also impose losses of pur-
6	106	10.00	9.43
6	106	10.00	9.43	chasing power on workers. Thus, workers are, in some sense,


NOTE: Each real wage figure is obtained by dividing the $10				“cheated” by inflation if they sign a contract specifying a fixed money
nominal wage by the corresponding price level a year later
nominal wage by the corresponding price level a year later				wage in an inflationary environment.
and multiplying by 100. Thus, for example, when the inflation				wage in an inflationary environment.
rate is 4 percent, the real wage at the end of the year is					Many economists doubt that workers will sign such contracts if
($10.00/104) 3 100 5 $9.62.
					they can see inflation coming. Wouldn’t it be wiser, these economists
					ask, to insist on being compensated for the coming inflation? After
TABLE 2
TABLE 2					all, firms should be willing to offer higher money wages if they ex-
Money and Real Wages under Expected Inflation
Money and Real Wages under Expected Inflation					pect inflation, because they realize that higher money wages need
	Expected		Expected Real
	Expected		Expected Real		not imply higher real wages.
Expected	Price Level	Wage per	Wage per		Table 2 illustrates the mechanics of such a deal. For example, if
Inflation	1 Year	Hour 1 Year	Hour 1 Year		people expect 4 percent inflation, the contract could stipulate that
Rate	from Now	from Now	from Now
Rate	from Now	from Now	from Now		the wage rate be increased to $10.40 (which is 4 percent more than
0%	100	$10.00	$10.00
0%	100	$10.00	$10.00		$10) at the end of the year. That would keep the real wage at $10
2	102	10.20	10.00
2	102	10.20	10.00		(because $10.40/1.04 5 $10.00), the same as it would be under zero
4	104	10.40	10.00
4	104	10.40	10.00		inflation. The other money wage figures in Table 2 are derived
6	106	10.60	10.00

similarly.

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