The trade-off between inflation and unemployment, Macroeconomics Video Lecture | Macro Economics - B Com

the short-run trade-off between
inflation and unemployment in the long
run inflation and unemployment are
unrelated let me repeat that in the long
run inflation and unemployment are
unrelated and the long run the inflation
rate depends mainly on the growth and
the money supply more money higher
prices less money supply lower prices
unemployment or the natural rate of
unemployment depends on the minimum wage
the market power of unions efficiency
wages and the process of a job search
now one of the ten principles of
economics is that in the short run
society faces a trade-off between
inflation and unemployment again in the
long run inflation and unemployment are
unrelated in the short run however
society does face a trade-off between
inflation and unemployment I want you to
think of us as a seesaw if one side of
the seesaw is up the other side is down
well if inflation is up unemployment is
down if unemployment is up inflation is
down in the short run key being in the
short run
now how we illustrate this is the
Phillips curve the Phillips curve shows
the short-run trade-off between
inflation and unemployment how did it
come about well 1958 aw Phillips showed
that the nominal wage growth was
negatively correlated with unemployment
in the United Kingdom in 1970 Paul
Samuelson and Robert Solow found a
negative correlation between US
inflation and unemployment and named it
the Phillips curve after aw Phillips
again all of this is in the short-run
so how do we derive it Phillips curve
well first let's suppose that price is
equal to 100 this year so let's say it's
a nominal price this year $100 the
following graph on the next slide shows
two possible outcomes for the next year
so this year versus next year aggregate
demand and in scenario a aggregate
demand is low there are small increases
in price which means there's low
inflation there's low output and high
unemployment in scenario B the aggregate
demand is high there's a big increase in
price
towards there is high inflation there's
high output and low unemployment now I
should remind you that output and
unemployment are negatively related over
business cycles which is one of the
three facts of economic fluctuations
that we discussed in the previous
chapter exploring aggregate demand and
aggregate supply so and looking at a and
B here
again an a we have lower aggregate
demand low inflation and a high
unemployment rate
if aggregate demand next year is low
compared to this year where the price is
$100 this is reflecting for example a
slow money growth then outcome a will
occur next year an outcome a the price
has risen to 103 dollars next year so
the inflation rate this year - next is
3% one from 100 200 3 the first output
we look here look at here output y1 is
relatively low so unemployment is
relatively high at 6% again low
inflation higher unemployment instead
look at scenario B where we have high
aggregate demand high inflation and low
unemployment rate if the aggregate
demand next year is high like in
scenario B this reflecting for example
rapid money growth and an outcome B will
occur the next year an outcome be the
price is 105 dollars so the inflation
rate from this year to next year went
from 100 to 105 so the inflation rate is
5 percent this would give us output y2
which is higher so unemployment is lower
more output need more workers so
inflation is higher and unemployment
slower there's that seesaw there is a
trade-off between inflation and
unemployment ok higher inflation lower
unemployment the lower inflation higher
unemployment
there's your seesaw ones up the others
down the others down are the one other
ones up other ones down now the Phillips
curve since fiscal and monetary policy
effect aggregate demand the Phillips
curve appeared to offer policymakers a
menu of choices again
and the short run policymakers can
choose from a policy menu that would say
hey let's have let's lower the
unemployment but it would increase the
inflation that's a trade-off or we can
have low inflation with higher
unemployment so do you want high prices
and low unemployment or do you want low
prices and high unemployment you could
also choose from a lot of things in
between again in the short run in the
1960s us status supported the Phillips
curve many believe that the Phillips
curve was stable and reliable even
beyond the short run now data seem to
perfectly trace out this downward
sloping Phillips curve but what's what's
important here is not just the negative
slope but also the economy's movement
over the years
fiscal policy was expansionary during
the time period you see on the slide
here in part because of the we needed to
finance the Vietnam War to keep interest
rates low the Fed made monetary policy
expansionary as well so there is
expansionary monetary policy and there's
more dollars out there on the market
that means there's a little cash inflow
and injected into the economy as a
result aggregate demand grew grew at a
rate that was that grew significantly
over the 1960s as you can see here you
can see this if you follow the points
year by year in for but inflation
gradually creeps up with unemployment
falling which is exactly what's this
picked it on the graphs we use to derive
the Phillips curve so you see here 1961
unemployment's coming down we have
expansionary fiscal policy but we put
more dollars out there what's happening
to price they're going up okay
unemployment's moving this way price is
moving up so we have inflation going up
so during the 1960's US policymakers
opted for reducing unemployment at the
expense of higher inflation think about
a linear line here just like we did back
here where we made sort of a linear
average line here and think about the
linear line that would represent this
line right here would be a downward
sloping line now
let's talk about the vertical long run
Phillips curve in 1968 Milton Friedman
in Edmund Phelps argued that the
trade-off was temporary it was just a
short-run deal they came up with the
natural rate hypothesis the claim that
unemployment eventually returns to his
normal natural rate regardless of the
inflation rate and again that's why I
put so much emphasis at the beginning of
this slide set that in the long run
unemployment and inflation are not
related
so the Phillips curve represents what's
going on in the short run now we base
this on the classic dichotomy that
dichotomy again means two categories
that one's inflation one's unemployment
and long-run they don't have anything to
do with each other and then also that we
have a vertical long-run aggregate
supply curve fixed on some level of
capability of output for country so at
some point you use up all your sources
like labor land and capital and
technology and you produce what you can
produce in the long run in the face of
what many considered overwhelming
evidence for the stability of a downward
sloping Phillips curve say even in the
long run Friedman and Phelps who
ironically were working on the same idea
separately this wasn't a joint research
project boldly asserted that any
trade-off will be purely temporary well
their logic that backed that up was the
classical dichotomy in the vertical
long-run aggregate supply curve and you
know what they're proven to be right
Phillips curve is a short-run
relationship so the vertical long run
Phillips curve in the long run faster
money growth only causes faster
inflation put more dollars out there
that's a long-run issue the dollar
becomes a little less valuable means it
takes more dollars to buy something so
when it could takes more dollars to buy
something prices are going up so in the
long run our long-run aggregate supply
is set at our natural rate of output
which we talked about an aggregate
demand and aggregate supply chapter in
the long run the long run Phillips curve
is going to have higher inflation with
expansionary monetary policy in low
inflation with less expansion Airi
monetary policy we're going to be a
fixed unemployment rate because in the
long run you're at your natural rate of
unemployment
it we know that there's going to be some
folks always looking for a job always in
transition in the long run we're going
to have a natural rate of unemployment
and just as a reminder and from the
unemployment chapter that rate in the
United States typically hovers around
5.5 percent so the greater the expansion
of the money supply the faster aggregate
demand will shift to the right resulting
in large increases in price in other
words higher inflation but this higher
inflation will not produce lower
unemployment in the long run
unemployment always goes to its natural
rate whether inflation is high or low in
the long run faster money growth only
causes faster inflation so let's
reconcile some theory and evidence here
the evidence from the 1960's says
Phillips curves going to always sloped
downward the theory that Friedman felt
separately came up with is well the
Phillips curve is vertical in the long
run which makes sense when you consider
the classical dichotomy of those two
things being two very separate things
and the fact that well in the long run
we can only produce what we can produce
it cannot go on indefinitely
so to bridge the gap between theory and
evidence Friedman and Phelps introduced
a new variable which is expected
inflation a measure of how much people
would expect the price level to change
now this took this this took a this was
very necessary to come up with basically
a workable Phillips curve equation where
we had inflation on one in and
unemployment on the other now when we're
talking about unemployment we could say
the unemployment rate equals the natural
rate of unemployment minus the effects
of inflation well the effects of
inflation is going to be represented
here by this little a but what Friedman
and Phillips asked us to consider excuse
me pardon me I skip a couple slides
there what Freeman and Phelps asked us
to consider was actual inflation versus
expected inflation now keep in mind
you've learned in this course that
expectations are huge in economics they
can really turn the market it's the
psychology portion of economics well in
the short run the Fed can reduce the
unemployment rate below the natural
unemployment rate by making inflation
greater than expected the seesaw they
can push unemployment down
even below the natural unemployment rate
by making him but the trade-off is
making inflation greater now in the long
run expectations catch up to reality
there's not a lot of guesswork in the
long run people have been around the
block unemployment rate goes back to the
natural rate of unemployment whether
inflation is high or low because well
unemployment and inflation are not
related in the long run this equation is
essentially the equation for aggregate
supply introduced in the aggregate
demand and aggregate supply chapter the
coefficient a let's call it alpha is a
positive number that measures the
relationship between unexpected
inflation and deviations of an
employment from its natural rate let's
say a 1% increase in inflation causes
unemployment rate to fall by alpha that
would be a proper interpretation of
alpha 4 so a 1% increase in inflation
causes unemployment rate to fall by
alpha okay so an increase in the
inflation rate causes the change in
unemployment alpha for the given values
in the natural rate and expected
inflation now I should point out to you
that this in this equation and it's
coefficient a alpha are very similar to
the equation for aggregate supply curve
and then again in the aggregate demand
and aggregate supply chapter now if the
Fed wants to reduce unemployment below
the natural rate it has to surprise
people with higher than anticipated
inflation this result this will will
result in lower unemployment but only
until people adjust their expectations
to a new reality of higher inflation so
prices are going sky-high raise like you
know some people that perhaps weren't
going to work decide to go to work so
that pushes unemployment below the
natural rate of unemployment but how you
have to do that is you have to push
prices way up eventually the
expectations catch up with reality so
for example people see inflation is
higher than they expected so they adjust
their expectations upward they adjust
their behavior and natural rate of
unemployment in the long run returns to
well where it's going to be at natural
rate of unemployment
now how expected inflation shifts the
the Phillips curve initially expected an
actual
inflation is 3% let's say the
unemployment rate is 6% the Fed makes
inflation 2% higher than expected and
the unemployment rate Falls to 4% okay
so was it 6% we go down the 4% because
we push the inflation rate from 3 to 5%
seesaw it's going back and forth in the
long run though expected inflation
increases to 5% and the Phillips curve
pushes upward and unemployment returns
to its natural rate now when people
adjust their inflation expectations
upward then the Phillips curve shifts up
as well each value of the unemployment
rate is associated then with a higher
inflation rate of course we can
extrapolate this and say something like
suppose the Fed wants to permanently
keep unemployment at 4 percent it must
continually raise inflation above
expectations but short-run adjustments
to get to where you want to be in the
long run these expectations will keep
adjusting upward so the Fed will have to
keep raising the inflation rate faster
than expectations are adjusting and as a
result inflation spirals upward and and
an attempt to keep unemployment below
the natural rate before long people will
come to expect not not only higher
inflation but ever-increasing inflation
and they will factor this into their
their behavior say if they're making
contracts with firms or if they're
consuming goods and services they're
going to expect there to be extreme
increases in the prices over time this
will this would make it extremely
difficult for the Fed to continue this
game so ultimately unemployment has to
return to its natural rate yet economy
will end up with something approaching
hyperinflation and the cost that imposes
on society so you got to be careful with
what you try to do with inflation over
time to control unemployment eventually
it unravels on you now you want to see
what it looks like when in arrivals here
you go
this chart adds a few additional years
to the data from the previous data chart
that we plotted now from 1969 to 1973
inflation and unemployment both increase
people were adjusting their expectations
of inflation upward causing the Phillips
curve Phillips curve to shift upwards
key word you're not moving along with
the old Phillips curve you're shifting
now I'll illustrate here listen
this is consistent with Friedman and
Phillips Phelps work which was looking
increasingly convincing to economists
and others now let's take a look at it
in early 1970s unemployment increased
despite higher inflation okay
Friedman Phelps explanation was was as
follows expectations were catching up
with reality and when expectations catch
up with reality the new reality is okay
we have our one line here that we saw
before 1961 to say 1968 be a pretty good
Phillips curve indicator and then we
push out here what in the world is going
on there we shift we're on a new line
out here okay this movement here to the
right is an illustration of people
adjusting their expectations and now if
we saw this carried out a little further
you would see an additional line out
here okay just like you have this we
have one coming forming right here okay
that has a relationship between
inflation and unemployment so imagine
two parallel lines here as your Phillips
curves okay it's hard when you look at a
year to year because you don't know if
you're adjusting expectations or if it's
on the Phillips curve itself this is
obviously a Phillips curve boom big
adjustment to expectations and then
we're forming another Phillips curve out
here so when the Phillips curve shifts
to the right
you're having increased numbers of
inflation and unemployment so naturally
it would make sense that both of them
are increasing because we're on a new
plane if you will we're on a new
Phillips curve out here so both of em
are higher as a higher stakes game but
we can still trade unemployment for
inflation but eventually you're just
going to keep pushing our downward now
let's look at another Phillips curve
shifter the supply shock a supply shock
is an event that directly alters firms
costs and prices shifting the aggregate
supply and the Phillips curve an example
will be a large increase in oil prices
okay the 1970s saw incredible increases
in the prices of oil largely driven by
OPEC which is an organization for
Petroleum Exporting Countries
that's basically a cartel of large
middle-eastern
oil producers that traditionally control
supply so they can pull supply way back
which would be a supply shock pull
supply way back there would be a large
increase in oil prices so in the chapter
aggregate demand and aggregate supply
you guys learned that adverse supply
shocks like an oil price increase shift
the short-run aggregate supply to the
left okay so we had supply out here of
oil and then we had a big decrease in
supply say from OPEC causing stagflation
falling output in rising prices which we
covered in the previous chapter we see
here that adverse supply shocks also
shift the short run Phillips curve to
the right and worsen the trade-off
between inflation and unemployment so we
had a trade-off between unemployment
inflation then we have a big shift to
the right we have increase in prices of
oil and affects your expectations and
then that also affects the market in
terms of the trade-off between
unemployment and inflation is much much
higher okay we're talking big percentage
trade offs here
seesaw gets a little further out there
right now the cost of reducing inflation
the term we want to focus on here's
disinflation a reduction in the
inflation rate so if you want to reduce
inflation that's called trying to get
dis inflation to reduce inflation the
Fed must slow the rate of money growth
so quit printing as much money quit
buying as many bonds lowering interest
rates which encourages more money out
there this reduces the aggregate demand
so if you slow the money growth you
reduce the aggregate demand now in the
short run output Falls and unemployment
rises okay so you're pulling down prices
through dis inflation however
unemployment is going to rise that's the
seesaw now in the long run it doesn't
matter output and unemployment are going
to return through their natural rates so
really the only variable mo on one is
the inflation and how your monetary
policy has affected that and long-run so
looking further at disinflationary
monetary policy contractionary monetary
policy from the economy moves the
economy from point A to point pardon me
or I'll have been there I did a slide
hop my apologies it's funny here we go
back here contractionary monetary policy
moves the economy from point A to point
B okay contractionary monetary policy is
going to keep us on the same Phillips
curve we're going to move from point A
to point B over time though the expected
inflation Falls meaning the the Phillips
curve shifts inwards so we go from B to
C in the long run at Point C the natural
rate of unemployment boom gets fixed
here and there's lower inflation okay
there's lower inflation because we did
this disinflationary monetary policy we
pulled some cash off the market prices
actually come down that's disinflation
but in the long run no matter what we're
going to get natural rate of
unemployment so we're moving down the
line real long a Phillips curve and then
we have a shift of a Phillips curve keep
that in mind
the cost of reducing inflation again
disinflation requires an enduring period
of high unemployment and low output
again if you want to bring inflation
down seesaw in the short run is going to
go up on the other end
dis inflation is getting higher this is
called the sacrifice ratio the
percentage points of annual output lost
per one percent one percentage point
reduction and inflation the typical
estimate of a sacrifice ratio ratio is
five so to reduce inflation by one
percent we must sacrifice five percent
of a year's output now you guys know me
by now year's output we're talking about
GDP five percent of GDP that's huge okay
now you can try to spread this cost out
over time for example to reduce
inflation by six percent and given the
sacrifice ratio of five
you can either sacrifice 30 percent of
GDP in one year that'd be crazy talk or
sacrifice 10 percent of GDP for three
years that's still huge okay that is
HUGE GDP higher GDP higher incomes
higher incomes better education better
health lower crime rates all down the
line so when you're giving up on GDP
you're giving up on a lot so typically
what we see is us giving up a little bit
of inflation to try to maintain
productivity now put in the economy now
rational expectations rata rational
expectations the theory that according
to which people optimally use
information they have so you use the
information you have on hand including
information about government policies
when forecasting the future you use
those expectations to affect your
behavior some early proponents of
rational expectations and really getting
some psychology and behavioral economics
into things early early proponents were
Robert Lucas Thomas Sergeant Robert
Barra you can learn more about those
guys in the reading this implied that
disinflation could be much less costly
suppose the Fed convinces everyone it is
committed to reducing inflation that
affects your expectations about where
inflation is heading ok then in the
short then expected inflation Falls your
expectation of inflation Falls the short
run Phillips curve shifts downward the
result is that this inflation can cause
less unemployment than traditional
sacrifice ratios now that's a lot of
words what does it mean okay push
inflation downwards you can change your
expectations which shifts your filip
curve back here so we push inflation
downwards and then eventually it shifts
the expectations which creates a new
Phillips curve in the short-run and
inflation is lower and you're in a
different plane now long-run you're
going to head towards this natural rate
of unemployment so let's take a look at
some Chairman's
Fed Chairman's behavior over time the
Volcker disinflation approach Fed
Chairman Paul Volcker was appointed in
late nineteen seventy seventy nine where
we had high inflation Henne
and unemployment okay so high above so
it sounds like to me we're on a higher
plane we're on a higher Phillips curve
okay now he changed the Fed policy to
disinflation he wanted to bring prices
down now from 1981 to 1984 fiscal policy
was expansionary okay so the Fed policy
had a very contractionary was it had to
become very contractionary to reduce
inflation the successes here was that
inflation fell from ten to four percent
but if you know if inflation
coming down the cost of high
unemployment is going up by the 1970s
the Phillips curve has shifted far to
the right so that's why unemployment and
inflation we're up think about that a 2b
we're on a higher Phillips curve out
there substantially worsening the feds
short-run trade-off between inflation
unemployment Volker thus knew that
monetary policy had to change if we were
going to bring those prices down what we
had to do is change the expectations for
inflation and shift that Phillips curve
inward now Volcker succeeded in bringing
inflation down but it was at the cost of
a deepest recession since the Great
Depression so it was a big decrease in
output which hurt a lot of things
imagine a downward sloping line going
through the points here from 1980 to
1982 or say through 1983 this imaginary
line is the short run Phillips curve at
its highest level the Fed pursued policy
that took the economy on a path similar
to that shown in the diagram a few
slides back removed from A to B and then
shifted a line to see on the ones we
were talking about disinflationary
monetary policy so here we have
incredible unemployment like near 10%
okay and then what does he do shifts
expectations and then we start forming a
new Phillips curve inward now this
disinflation turned out to be quite
costly because we had a decrease in GDP
on a significant level which affected
income which affected you know output
which affected your quality of life now
let's jump ahead to Alan Greenspan who
came in let's take a look Greenspan was
shortly after Volcker so 1986 oil prices
fell by 50% we had less of a issue with
the supply shock we had under Volcker
which was obviously not his fault and
then from 1989 to 90 and inflation rose
there yours there's your seesaw
short-run trade-off the Fed raised
interest rates and cut which caused a
mild recession feds raise interest rates
that's bringing more money off the
market reason being interest rates are
higher that's the price firms pay to
invest in their company say build a new
factory they have to take out a loan and
the price of taking out a loan the
interest rate went up so they're doing
less of that also if the interest rates
are higher
it's a better time for you to save than
it is for you to spend because you earn
a greater return of the higher interest
rates of people are spending less money
thus the mild recession now in 1990s the
unemployment and the inflation rate fell
in 2001 negative demand shocks created
the first recession in a decade
policymakers responded by off by doing
expansion airy monetary and fiscal
policy physicals policies government
spending they decide to spend more in
the government to up GDP expansionary
monetary policy decided to print more
money buy back bonds and lower the
interest rate which all floods the money
with cash you get cash in your pocket
you go spend it so it's a little bit of
a a little bit of a an attempt to
resuscitate the market now in Greenspan
look at this mess holy smokes
and this period inflation unemployment
were lower and less variable than
previous periods now a few highlights
here really quickly 19 1992 there was
rising employment at 92 92 okay you had
rising and unemployment that resulted in
the first recession its period from 92
to say 98 ok yet unemployment falls
without a corresponding increase in
inflation in fact inflation edged lower
to me that sounds like you're on a plane
up here on a phillips curve now you're
shifting expectations in now you're
forming a new plane here now from 98 to
2000 98 to 2000 okay that looks like a
little new inward Phillips curve here
yes small increases in inflation while
unemployment continues its downward
march trading off inflation for lower
unemployment now for 2001 to 2003 moving
this way okay there's a rising
unemployment followed by a second
recession this period looks like to me
we're shifting our Phillips curve back
inward okay so there's another shift in
the Phillips curve we're changing our
expectations now from 2003 to 2006
there's expansionary fiscal policy and
monetary policy that was also
expansionary that reduced unemployment
at the cost of slightly higher
unemployment inflation so that's that
middle line here we reduced unemployment
back this way from these point
point no.6 and a5 but inflation was
rising so I would wager to say here we
have three Phillips curves here in two
adjustments in expectations we had a
Phillips curve running about like this
and adjustment the Phillips curve around
here okay we're trading inflation and
unemployment and then another adjustment
expectations and a Phillips curve here
okay so imagine those three lines there
and hopefully that helps you illustrate
the trade-offs again this is all
short-run inflation when unemployment
were low during most of Alan Greenspan's
years as Fed Chairman now along comes
Ben Bernanke the Phillips curve during
the financial crisis poor Ben in the
early two-thousands he inherited a
housing bubble he didn't know it but the
housing market boom turned into a bus by
2006 household wealth fell because they
were propped up on houses they weren't
worth as much as the market was trying
to tell them
millions of mortgage defaults and
foreclosures resulted and there was
heavy losses at financial institutions
in fact they were so heavy there had to
be some bailouts so the result is a
sharp drop in aggregate demand and steep
rise in unemployment sharp drop in
aggregate demand people want to buy less
things because they're less wealthy
people want to buy less things people
are going to sell firms are going to
sell us things they sell less things
they're going to hire less people on
employment is going up okay and trust me
housing prices went way down so that's
some serious disinflation now the
Phillips curve doing the and after
during and after the financial crisis
from 2006 to 2009 the financial crisis
caused the aggregate demand plummet as
we discussed in the previous slide
sharply increasing unemployment and
reducing inflation just as we had
discussed now from 2010 to 2012 a slow
recovery reduced unemployment and
increased inflation so you have a slow
recovery where we traded off some
unemployment for increased prices so
again he'll linecount over here and
online kinda over here now hopefully
this was very straightforward conclusion
here is the theories in this chapter
come from some of the greatest
economists in the twentieth century they
teach us that inflation and unemployment
are as follows unrelated in the long run
again I can't stress that enough
unrelated in the long run they're going
to give their natural levels negatively
related in the short run
there's a trade-off one goes up there
goes down they're affected by
expectations as is everything in
economics which played an important role
in the economy's adjustment force from
the short run to the long run that's why
that Phillips curve keeps moving around
on us
so in summary the Phillips curve
describes the short-run trade-off
between inflation and unemployment in
the long run there is no trade-off
inflation is determined by money growth
while unemployment equals its natural
rate see a flash and long runs all
depending on how much money we get out
there and unemployment long-run is going
to go that natural rate supply shocks
and changes in expected inflation shift
the short run Phillips curve making the
trade-off more or less favorable
Phillips curves going to move the Fed
can reduce inflation by contracting the
money supply which moves the economy
along its short run Phillips curve and
raises unemployment okay in the long run
the expectations suggest an unemployment
returns to its natural rate so whatever
the Fed wants to do is really a
short-run type deal some economists
argue that a credible commitment to
reducing inflation can lower the cost of
disinflation by inducing a rapid
adjustment and expectations it can shift
that Phillips curve all the way inwards
okay which we've Illustrated several
slides here now this wraps up my lush
PowerPoint lecture on the short-run
trade-off between inflation and
unemployment obviously there's a lot
more nuggets to be garnered from the
reading if you have any questions please
let me know I'll be happy to answer them
for you this is one of those again one
of those chapters where you know it's a
lot of new stuff so you probably have to
go through it like more than once
hopefully this video will help you with
that if you'd like to watch it again I
would encourage that please let me know
if you have any questions