princch35presentation

short run? In the long run?
▪ What factors alter this relationship? ▪ What is the short-run cost of reducing inflation? ▪ Why were U.S. inflation and unemployment both so
▪ The following graphs show two possible
outcomes for next year:
A. Agg demand low, small increase in P (i.e., low inflation), low output, high unemployment.
D. Instead, suppose the natural rate falls to 4%. Draw the new long-run Phillips curve, then repeat part B.
13
ACTIVE LEARNING 1
Answers
An increase
7
LRPCD
Inflation rate (% per year)
10
8
6
During the 1960s, U.S. policymakers opted for reducing
unemployment at the expense of
higher inflation
4
68
66
2
67 65
62 1961
64 63
▪ Supply shock:
an event that directly alters firms’ costs and prices, shifting the AS and PC curves
B. Find the u-rate for each of these values of actual inflation: 0%, 6%. Sketch the short-run PC.
C. Suppose expected inflation rises to 4%. Repeat part B.
a negative correlation between U.S. inflation & unemployment, named it “the Phillips Curve.”
THE SHORT-RUN TRADE-OFF
3
Deriving the Phillips Curve
▪ Suppose P = 100 this year.
PCB
LRPCA
in expected
6
inflation
shifts PC to
5
inflation rate
the right.
4
PCD
3
A fall in the
2
PCC
natural rate
shifts both
1
curves
0
to the left.
012345678
unemployment rate
THE SHORT-RUN TRADE-OFF
10
The Phillips Curve Equation
Unemp. rate
=
Natural
rate of –
unemp.
a
Actual inflation
–
Expected inflation
Short run Fed can reduce u-rate below the natural u-rate by making inflation greater than expected.
▪ Since fiscal and mon policy affect agg demand,
the PC appeared to offer policymakers a menu of choices:
▪ low unemployment with high inflation ▪ low inflation with high unemployment ▪ anything in between
14
The Breakdown of the Phillips Curve
Inflation rate (% per year)
Early 1970s:
unemployment increased,
10
despite higher inflatiFornie. dman &
8
Phelps’
explanation:
▪ 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:
Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low.
THE SHORT-RUN TRADE-OFF
11
How Expected Inflation Shifts the PC
low in the 1990s?
1
Introduction
▪ In the long run, inflation & unemployment are
unrelated:
▪ The inflation rate depends mainly on growth in
the money supply.
6
73
expectations
69 70 71
4
68
72
66
2
67 65
62 1961
64 63
0
0
2
4
6
8
THE SHORT-RUN TRADE-OFF
were catching up with reality.
10 Unemployment rate (%)
15
Another PC Shifter: Supply Shocks
between inflation and unemployment
▪ 1958: A.W. Phillips showed that
nominal wage growth was negatively correlated with unemployment in the U.K.
▪ 1960: Paul Samuelson & Robert Solow found
u-rate
12
ACTIVE LEARNING 1
A numerical example
Natural rate of unemployment = 5% Expected inflation = 2% In PC equation, a = 0.5
A. Plot the long-run Phillips curve.
35 C H A P T E R
The Short-Run Trade-off Between Inflation and Unemployment
Economics P R I N C I P L E S O F N. Gregory Mankiw
Premium PowerPoint Slides by Ron Cronovich
▪ 1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.
THE SHORT-RUN TRADE-OFF
6
Evidence for the Phillips Curve?
P
inflation
SRAS
B 105
5%
B
A
103
AD2
3%
A
PC AD1
Y1 Y2
Y
4% 6% u-rate
B. High agg demand, high inflation, low u-rate
THE SHORT-RUN TRADE-OFF
5
The Phillips Curve: A Policy Menu?
vertical LRAS curve
THE SHORT-RUN TRADE-OFF
8
The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes faster illy, expected & actual inflation = 3%,
unemployment = natural rate (6%).
inflation
Fed makes inflation
2% higher than expected, 5% u-rate falls to 4%.
In the short run, society faces a trade-off between inflation and unemployment.
THE SHORT-RUN TRADE-OFF
2
The Phillips Curve
▪ Phillips curve: shows the short-run trade-off
inflation
LRPC
high
P2
infla-
tion
P1
AD2
low
infla-
AD1
tion
Y Natural rate
of output
Natural rate of unemployment
u-rate
9
Reconciling Theory and Evidence
▪ Evidence (from ’60s):
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In this chapter, look for the answers to these questions:
▪ How are inflation and unemployment related in the
▪ Natural-rate hypothesis: the claim that
unemployment eventually returns to its normal or “natural” rate, regardless of the inflation rate
▪ Based on the classical dichotomy and the
In the long run,
3%
expected inflation
increases to 5%,
PC shifts upward,
unemployment returns to
its natural rate.
THE SHORT-RUN TRADE-OFF
LRPC
BC
A 4% 6%
PC2 PC1
B. Agg demand high, big increase in P (i.e., high inflation), high output, low unemployment.
THE SHORT-RUN TRADE-OFF
4
Deriving the Phillips Curve
A. Low agg demand, low inflation, high u-rate
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 inflation – a measure of how much people expect the price level to change.
0
0
2
4
6
8
THE SHORT-RUN TRADE-OFF
10 Unemployment rate (%)
7
The Vertical Long-Run Phillips Curve
▪ 1968: Milton Friedman and Edmund Phelps
argued that the tradeoff was temporary.