The Short-Run Trade-Off between Inflation & Unemployment, University of Limerick

Recommended Reading, Tasks & Reminders

• Reading: using MindTap ebook, study Chapter 30 (The Short-Run Trade-Off between Inflation and Unemployment), Mankiw & Taylor 2023
• Tasks: Complete associated exercises in Chap 30: e.g., Self Evaluation Questions, Check your Understanding Practice questions, Video Concepts, Problem Walk Through ...

Reminders

• Test 4 - online (via MindTap): opens Week 12, Monday @ 09h00 on 21 April
• Test 4 closes: completion deadline is Friday, Week 12 @ 15h00 (25 April 2025).
• Test 4: 30 minutes to complete Test with 20 questions (MCQ style)
• One take of Test - only open once ready & prepared
• Please do not leave it too close to this deadline to complete
• Refer to Brightspace' sub-folder: Plan Tests (MindTap) EC4112

Inflation & Unemployment

• The natural rate of unemployment depends on various features of the labour 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 central bank

Unemployment & Inflation Trade-off

• Society faces a short-run trade-off between unemployment (UE) and inflation ( )
• If policymakers: Expand aggregate demand (AD), they can lower unemployment, but only at the cost of higher inflation Contract AD, they can lower inflation, but at the cost of temporarily higher unemployment

Origins of the Phillips Curve

• The Phillips Curve (PC) illustrates the short-run relationship between inflation and unemployment
• describing a negative relationship between inflation and unemployment
• In 1958, A.W. Phillips showed the relationship between unemployment and the rate of change of money wages in the UK, 1861-1957
• Samuelson and Solow extended Phillips' finding to the USA
• this had implications for policymakers

Figure 1. The Phillips Curve

Inflation Rate (percent per year) B 6 A 2 Phillips Curve 0 4 7 Unemployment Rate (percent)

Figure 2. Phillips Curve and Aggregate Demand/Supply Model

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve Inflation Rate (percent per year) B 6 A 2 Phillips Curve 0 7 4 (Output is 8,000) (Output is 7,500) Unemployment Rate (percent)

Price Level Short-Run Aggregate Supply B 106 A 102 High Aggregate Demand Low Aggregate Demand 0 7,500 8,000 (Unemployment (Unemployment is 7%) is 4%) Quantity of OutputGiven that Monetary & Fiscal policy can both shift the AD curve, these types of policies can move the economy along the PC Increases in the money supply, increases in government spending, or decreases in taxes all increase AD and move the economy to a point on the PC with lower unemployment and higher inflation Decreases in the money supply, decreases in government spending, or increases in taxes all lower AD and move the economy to a point on the PC with higher unemployment and lower inflation

Phillips' Scatter Diagram: Wage II & UE (1860-1957)

Inflation (9%) Phillips Curve Unemployment (96)

Phillips Curve: Inverse Relationship

Inflation Rate (%) Phillips Curve 6 B A 2 2 4 Unemployment Rate (%)

The Original Phillips Curve

• Based Figure in last slide: Economy at A: II =2%, UE=4%.
• Expansionary fiscal policy: economy: economy to point B: II=6%, UE=2%
• Lower unemployment for higher inflation
• It quickly became accepted that policy-makers could exploit the so-called trade-off between UE and ,
• i.e., a little more UE meant a little less IT

Disillusionment with the Phillips Curve

• Stagflation (1970's): a combination of stagnant economic growth, high unemployment and high inflation
• Output is falling at the same time as prices are rising
• Explanations: trade union militancy; skills mismatch, generous social welfare system
• Non-Accelerating Inflation Rate of Unemployment (NAIRU)
• Rate of unemployment when the rate of wage inflation is stable

The Long-Run Phillips Curve

• In the 1960s, Milton Friedman & Edmund Phelps concluded that inflation and unemployment are unrelated in the long-run ... i.e., no trade-off:
• While there is a short-run trade-off between unemployment and inflation, it has not been observed in the long-run.
• Friedman & Phelps asserted that the PC was only applicable in the short-run and that, in the long-run, inflationary policies would not decrease unemployment
• They offered one explanation: there is not one PC but a series of short-run PCs, and a long-run PC which exists at the natural rate of unemployment (NRU)
• The Original PC ignored price expectations in wage negotiations
• The long-run PC is vertical at the natural rate of unemployment
• The long-run PC is now seen as a vertical line at the natural rate of unemployment, where the rate of inflation has no effect on unemployment
• Increases in AD lead only to changes in the price level and have no effect on the economy's level of output
• Friedman, who criticised the basis for the original PC (in 1968) introduced the concept of the NAIRU

Money Illusion: belief that an increase in money wages is the same as an increase in real wages

• The conclusion drawn was that any attempt to push unemployment below its natural rate would cause accelerating inflation, with no long-term job gains
• The only way to reverse this process would be to raise unemployment above the NRU so that workers revised their expectations of inflation downwards, and the economy moved to a lower short-run Phillips Curve

Figure 3. The Long-Run Phillips Curve

Inflation Rate Long-Run Phillips Curve B 1. When the central bank increases the growth rate of the money supply, the rate of inflation increases . . . High Inflation A Low Inflation 2. . . . but unemployment remains at its natural rate in the long-run 0 Natural Rate of Unemployment Unemployment Rate

Figure 4. Long-Run Phillips Curve and Aggregate Demand/Supply Model

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve Price Level Long-Run Aggregate Supply Inflation Rate Long-Run Phillips Curve 3. . . . and increases the inflation rate B 2. .. . raises the price level . . . y A P. A AD2 Aggregate demand, AD 0 Natural Rate of Output Quantity of Output 0 Natural Rate of Unemployment Unemployment Rate 4. . . . but leaves output and unemployment at their natural rates

1. An increase in the money supply increases aggregate demand . B P2Reconciling Theory and Evidence

• 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 Central Bank's ability to create unexpected inflation exists only in the short-run
• Once people anticipate a particular rate of inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate

The Short-Run Phillips Curve

• The 'Short-Run Phillips Curve' is also called, the 'Expectations-Augmented Phillips Curve', since it shifts up when inflationary expectations rise, according to Friedman & Phelps
• In the long-run, this implies that monetary policy cannot affect unemployment which adjusts back to its 'natural rate', also called the 'NAIRU' or 'long-run Phillips curve'
• Relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation:
• The Unemployment Rate = NRU - a(Actual inflation - expected inflation)
• Because expected inflation is already given in the short-run, higher actual inflation leads to lower unemployment

Figure 5. How Expected Inflation shifts the Short-Run Phillips Curve

2. . . . but in the long run, expected inflation rises, and the Short-Run Phillips Curve shifts to the right Inflation Rate Long-Run Phillips Curve C B --- - Short-Run Phillips Curve with high expected inflation A 1. Expansionary policy moves the economy up along the Short-Run Phillips Curve . . . Short-Run Phillips Curve with low expected inflation 0 Natural rate of Unemployment Unemployment Rate

The Unemployment-Inflation Trade-Off

• The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the Natural-Rate Hypothesis
• Historical observations supported the natural-rate hypothesis
• The stable PC relationship between inflation and unemployment broke down in the early '70s
• During the '70s and '80s, many economies experienced high inflation and high unemployment simultaneously
• UK & US: supply-side policies to expand productive capacity of the economy to shift the AS curve to the right
• Shift to the left of the PC in the UK
• How to explain high European unemployment in the 21st century - center on the level of labour market regulation