Short Run Trade Off Between Inflation and Unemployment

Unemployment and Inflation

The natural rate of unemployment depends on various features of the labor market. Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. The inflation rate depends primarily on growth in the quantity of money, controlled by the RBI.

Trade Off
Society faces a short-run tradeoff between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

Phillips Curve
A W Phillips- New Zealand Economist Analyzed statistical data concerning unmpt % and wage % in Britain during the period 1861 to 1957. Found that wage rate rose rapidly when unemployment was low; decreased when it was high The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve

Inflation Rate (percent per year) 6 B

A Phillips curve

Unemployment Rate (percent)

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THE SHORT-RUN PHILLIPS CURVE The expected

inflation rate is 3 percent a year.

The natural unemployment rate is 6 percent.

This combination, at point B, provides the anchor point for the short-run Phillips curve.

AD, AS, and Phillips Curve

The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. The greater the aggregate demand for goods and services, the greater is the economys output, and the higher is the overall price level. A higher level of output results in a lower level of unemployment.

(a) The Model of Aggregate Demand and Aggregate Supply Price Level Short-run aggregate supply B A High aggregate demand Low aggregate demand Inflation Rate (percent per year) 6

(b) The Phillips Curve

106 102

A 2 Phillips curve

7,500 8,000 (unemployment (unemployment is 7%) is 4%)

Quantity of Output

4 (output is 8,000)

Unemployment 7 (output is Rate (percent) 7,500)

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 Phillips curve- inverse relation Rate of wage inflation decreases with the unemployment rate. Rate of wage inflation, gw= Wt+1 Wt

/W

gw = - (u-un) Implies that wages will fall when the actual unemployment rate exceeds the natural rate Will rise when actual unemployment rate is below the natural rate.

 The inverse relation- reasons

Relative bargaining strength of trade unions and management Generalized excess demand for labour Imbalances b/w supply and demand in labour market.

 Phillips curve that Economists use today differs in three ways from the relationship Phillips examined Modern Phillips curve substitutes price inflation for wage inflation Includes expected inflation Includes supply shocks

Long-Run Phillips Curve

In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. Monetary policy could be effective in the short run but not in the long run.

The Long-Run Phillips Curve

Inflation Rate

Long-run Phillips curve B

1. When the RBI increases the growth rate of the money supply, the rate of inflation increases . . .

High inflation

Low inflation

2. . . . but unemployment remains at its natural rate in the long run.

Natural rate of unemployment

Unemployment Rate

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(a) The Model of Aggregate Demand and Aggregate Supply

(b) The Phillips Curve Long-run Phillips curve 3. . . . and increases the inflation rate . . . B

Price Level

P2 2. . . . raises the price P level . . .

Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand . . . A AD2 Aggregate demand, AD

Inflation Rate

Natural rate of output

Quantity of Output

Natural rate of unemployment

Unemployment Rate

4. . . . but leaves output and unemployment at their natural rates.

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Expectations and Short-Run Phillips Curve

Expected inflation measures how much people expect the overall price level to change. In the long run, expected inflation adjusts to changes in actual inflation. The Feds ability to create unexpected inflation exists only in the short run.
Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

Formula
Unemployment Rate=Natural Rate of Unemployment- a {Actual Inflation Expected Inflation}

How Expected Inflation Shifts the Short-Run Phillips Curve

Inflation Rate

2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right.
Long-run Phillips curve

C Short-run Phillips curve with high expected inflation

A
1. Expansionary policy moves the economy up along the short-run Phillips curve . . . 0

Short-run Phillips curve with low expected inflation Unemployment Rate

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Natural rate of unemployment

Shifts in Short-Run Phillips Curve

The short-run Phillips curve also shifts because of shocks to aggregate supply.
Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

An Adverse Shock to Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply Price Level AS2 Inflation Rate

(b) The Phillips Curve 4. . . . giving policymakers a less favorable tradeoff between unemployment and inflation. B A PC2

Aggregate supply, AS

P2

B A

3. . . . and raises the price level . . .

1. An adverse shift in aggregate supply . . . Aggregate demand

Phillips curve, P C 0 Unemployment Rate

Y2

Y 2. . . . lowers output . . .

Quantity of Output

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Cost of Reducing Inflation

To reduce inflation, the Fed has to pursue contractionary monetary policy. When the Fed slows the rate of money growth, it contracts aggregate demand. This reduces the quantity of goods and services that firms produce. This leads to a rise in unemployment. To reduce inflation, an economy must endure a period of high unemployment and low output. When the Fed combats inflation, the economy moves down the short-run Phillips curve. The economy experiences lower inflation but at the cost of higher unemployment.

Disinflationary Monetary Policy in the Short Run and the Long Run
Inflation Rate A Long-run Phillips curve 1. Contractionary policy moves the economy down along the short-run Phillips curve . . .

Short-run Phillips curve with high expected inflation C

B Short-run Phillips curve with low expected inflation

Natural rate of unemployment

Unemployment 2. . . . but in the long run, expected Rate inflation falls, and the short-run Phillips curve shifts to the left.
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Sacrifice Ratio
The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.
An estimate of the sacrifice ratio is five.

Rational Expectations and Possibility of Costless Disinflation

The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run. How quickly the short-run tradeoff disappears depends on how quickly expectations adjust. The theory of rational expectations suggests that the sacrificeratio could be much smaller than estimated.