Lesson 16-1 Relating Inflation and Unemployment

1. Lesson 16-1 Relating Inflation and Unemployment

2. The Phillips Curve A Phillips curve suggests a negative relationship between inflation and unemployment. The Phillips curve trade-off between inflation and unemployment is implied by Keynesian analysis. The experience of the 1960s suggested that the Phillips curve did exist in the United States.

3. The Phillips Curve Goes Awry In the 1970s, both the unemployment rate and the inflation rate rose and fell simultaneously. The 1960s appear to be atypical. Empirical evidence shows no sign of a meaningful Phillips Curve relationship over the period 1961 to 1998.

4. The Cycle of Inflation and Unemployment The Phillips phase is a period in which inflation rises as unemployment falls. The stagflation phase is a period marked by high inflation and increasing unemployment. The recovery phase is a period in which inflation and unemployment both decline. The inflation-unemployment cycle is the pattern of a Phillips phase, stagflation phase, and recovery phase observed in the relationship between inflation and unemployment. The data show that the economy went through three inflation-unemployment cycles during the 1970s.

5. Explaining the Inflation-Unemployment Cycle The Phillips Phase: Increasing Aggregate Demand Start from a recessionary gap to which authorities respond with expansionary monetary or fiscal policy. Aggregate demand increases, pushing real GDP and the price level up along the short-run aggregate supply curve and lowering unemployment. Impact lags in macroeconomic policy lead to continuing increases in aggregate demand in subsequent periods and the repetition of the process above.

6. The rising employment and real GDP occur because sticky prices and wages that in the face of nominal price increases are reduced in value give an incentive to expand employment. Eventually workers and firms will begin adjusting nominal wages and other sticky prices to reflect the new higher level of prices that emerges during the Phillips phase.

7. Changes in Expectations and the Stagflation Phase Workers and firms adjust their expectations to a higher price level, resulting in new agreements on wages with higher nominal wages. Higher wages cause a leftward shift of the short-run aggregate supply curve. This decrease in the short-run aggregate supply curve results in increases in both unemployment and inflation. The essential feature of the stagflation phase is a change in expectations.

8. The Recovery Phase Government attempts to stop the recession created in the stagflation phase. Expansionary macroeconomic policy shifts the aggregate demand to create a new equilibrium of aggregate demand and SRAS. This results in lower unemployment and higher prices, but the price rise is less than before, so the inflation rate is lower. There are other determinants of inflation and unemployment.

9. Changes in production costs shift the short-run aggregate supply curve. Depending on when such shifts occur, they can reinforce or reduce the swings in inflation and unemployment. Lags also play a crucial role in the cycle. Because of the lags in expansionary policy policymakers may respond a second time too quickly and create overstimulation in subsequent periods.