10.

The Relationship
between Unemployment
and Inflation
Abel, Bernanke and Croushore
(chapter 12.1)

Syllabus Outline
Introduction to Macroeconomics
2.
The measurement and structure of the national economy
3.
Goods market equilibrium: the IS curve
4.
Money market equilibrium: the LM curve
5.
The IS-LM model
6. Demand-side policies in the IS-LM model (Keynesian
Macroeconomics)
7.
The Aggregate Supply curve
8.
Classical Macroeconomics in the AD-AS model
9.
Keynesian Macroeconomics in the AD-AS model
10. The relationship between Unemployment and Inflation
1.

Goals of the chapter

A) Why study unemployment and inflation
together?
1. The most important macroeconomic
problems
2. Phillips curve relationship
B) Study relationship between inflation and
unemployment
1. Has it changed over time?
2. Is there a trade-off between inflation
and unemployment?
3

Unemployment and Inflation:

Is There a Trade-off? (Sec. 12.1)
A) Many people think there is a trade-off between inflation and
unemployment
1. The idea originated in 1958 when A.W. Phillips showed a
negative relationship between unemployment and nominal
wage growth in Britain
2. Since then economists have looked at the relationship between
unemployment and price inflation (Samuelson and Solow, 1960)
3. In the 1950s and 1960s many nations seemed to have a negative
relationship between the two variables
4. The United States appears to be on one Phillips curve in the
1960s (text Figure 12.1)
5. This suggested that policymakers could choose the
combination of unemployment and inflation they most desired
6. But the relationship fell apart in the following three decades
(text Figure 12.2)
7. The 1970s were a particularly bad period, with both high inflation
and high unemployment, inconsistent with the Phillips curve
4

Figure 12.1 The Phillips curve and the U.S. economy during the 1960s

Figure 12.2 Inflation and unemployment in the United States, 19702002

Unemployment and Inflation:

Is There a Trade-off?
B) The expectations-augmented Phillips curve
1. Friedman and Phelps: The cyclical unemployment
rate (the difference between actual and natural
unemployment rates) depends only on unanticipated
inflation (the difference between actual and expected
inflation)
a. This theory was made before the Phillips curve
began breaking down in the 1970s
b. It suggests that the relationship between
inflation and the unemployment rate isnt
stable
2. How does this work in the extended classical
7
model?

Unemployment and Inflation:

Is There a Trade-off?
B) The expectations-augmented Phillips curve (cont.)
2. How does this work in the extended classical model?
a. First case: anticipated increase in money supply (text Figure 12.3)

(1) AD shifts up and SRAS shifts

up, with no misperceptions
(2) Result: P rises, Y unchanged
(3) Inflation rises with no change in
unemployment

Unemployment and Inflation:

Is There a Trade-off?
B) The expectations-augmented Phillips curve (cont.)
2. How does this work in the extended classical model?
b. Second case: unanticipated increase in money supply (text Figure 12.4)
(1) AD expected to shift up to AD2, old (money
supply expected to rise 10%), but
unexpectedly money supply rises 15%, so
AD shifts further up to AD2, new
(2) SRAS shifts up based on expected 10% rise
in money supply
(3) Result: P rises and Y rises as
misperceptions occur
(4) So higher inflation occurs with lower
unemployment
9

(5) Long run: P rises further, Y declines to fullemployment level

Unemployment and Inflation:

Is There a Trade-off?
B) The expectations-augmented Phillips curve (cont.)
2. How does this work in the extended classical model?
c. Expectations-augmented Phillips curve:

e h(u u )
(1) When e, u

(2) When < e, u >

(3) When > e, u <

(12.1)

10

Unemployment and Inflation:

Is There a Trade-off?
C) The shifting Phillips curve
1. The Phillips curve shows the relationship between
unemployment and inflation for a given expected rate of
inflation and natural rate of unemployment
2. Changes in the expected rate of inflation (text Figure 12.5)
u

a. For a given expected rate of

inflation, the Phillips curve shows
the trade-off between cyclical
unemployment and actual inflation
b. The Phillips curve is drawn such that
= e when u = u
c. Higher expected inflation implies a
higher Phillips curve
11

Unemployment and Inflation:

Is There a Trade-off?
C) The shifting Phillips curve (cont.)
3. Changes in the natural rate of unemployment (text Figure 12.6)

a. For a given natural rate of

unemployment, the Phillips curve
shows the trade-off between
unemployment and unanticipated
inflation
b. A higher natural rate of
unemployment shifts the Phillips
curve to the right

12

Unemployment and Inflation:

Is There a Trade-off?
C) The shifting Phillips curve (cont.)
4. Supply shocks and the Phillips curve
a. A supply shock increases both expected inflation and the
natural rate of unemployment
(1) A supply shock in the classical model increases the
natural rate of unemployment, because it increases the
mismatch between firms and workers
(2) A supply shock in the Keynesian model reduces the
marginal product of labor and thus reduces labor demand
at the fixed real wage, so the natural unemployment rate
rises

b. So an adverse supply shock shifts the Phillips curve up and

to the right
c. The Phillips curve will be unstable in periods with many
13
supply shocks

Unemployment and Inflation:

Is There a Trade-off?
C) The shifting Phillips curve (cont.)
5. The shifting Phillips curve in practice
a. Why did the original Phillips curve relationship apply to
many historical cases?
(1) The original relationship between inflation and
unemployment holds up as long as expected
inflation and the natural rate of unemployment are
approximately constant
(2) This was true in the United States in the 1960s, so
the Phillips curve appeared to be stable

14

Unemployment and Inflation:

Is There a Trade-off?
C) The shifting Phillips curve (cont.)
5. The shifting Phillips curve in practice
b. Why did the U.S. Phillips curve disappear after 1970?
(1) Both the expected inflation rate and the natural rate of
unemployment varied considerably more in the 1970s
than they did in the 1960s
(2) Especially important were the oil price shocks of 1973
1974 and 19791980
(3) Also, the composition of the labor force changed in the
1970s and there were other structural changes in the
economy as well, raising the natural rate of
unemployment
(4) Monetary policy was expansionary in the 1970s, leading
to high and volatile inflation
(5) Plotting unanticipated inflation against cyclical
15
unemployment shows a fairly stable relationship since
1970 (text Figure 12.7)

Figure 12.7 The expectations-augmented Phillips curve in the United States,

19702002

16

Unemployment and Inflation:

Is There a Trade-off?
D) Macroeconomic policy and the Phillips curve
1. Can the Phillips curve be exploited by policymakers?
Can they choose the optimal combination of
unemployment and inflation?
a. Classical model: NO
(1) The unemployment rate returns to its natural level quickly,
as peoples expectations adjust
(2) So unemployment can change from its natural level only
for a very brief time
(3) Also, people catch on to policy games; they have rational
expectations and try to anticipate policy changes, so
there is no way to fool people systematically
17

Unemployment and Inflation:

Is There a Trade-off?
D) Macroeconomic policy and the Phillips curve
1. Can the Phillips curve be exploited by policymakers?
Can they choose the optimal combination of
unemployment and inflation?
b. Keynesian model: YES, temporarily
(1) The expected rate of inflation in the Phillips curve is the
forecast of inflation at the time the oldest sticky prices
were set
(2) It takes time for prices and expected prices to adjust, so
unemployment may differ from the natural rate for some
time

18

Unemployment and Inflation:

Is There a Trade-off?
D) Macroeconomic policy and the Phillips curve
2. Box 12.1: The Lucas critique
a. When the rules of the game change, behavior changes
b. For example, if batters in baseball were called out after two strikes
instead of three, theyd swing more often when they have one strike
than they do now
c. Lucas applied this idea to macroeconomics, arguing that historical
relationships between variables wont hold up if theres been a
major policy change
d. The Phillips curve is a good exampleit fell apart as soon as
policymakers tried to exploit it
e. Evaluating policy requires an understanding of how behavior will
change under the new policy, so both economic theory and
empirical analysis are necessary
19

Unemployment and Inflation:

Is There a Trade-off?
E) The long-run Phillips curve
1. Long run: u = u for both Keynesians and classicals
2. The long-run Phillips curve is vertical, since when e, u
(text Figure 12.8)

20

Unemployment and Inflation:

Is There a Trade-off?
E) The long-run Phillips curve
3. Changes in the level of money supply have no long-run real
effects; changes in the growth rate of money supply have no
long-run real effects, either
4. Even though expansionary policy may reduce unemployment only
temporarily, policymakers may want to do so if, for example,
timing economic booms right before elections helps them (or
their political allies) get reelected

21