WHAT’S NEW IN THE EIGHTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
why policymakers face a short-run trade-o between ination and unemployment.
why the ination-unemployment trade-o disappears in the long run.
how supply shocks can shift the ination-unemployment trade-o.
the short-run cost of reducing ination.
589
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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THE SHORT-RUN
TRADE-OFF BETWEEN
INFLATION AND
UNEMPLOYMENT
35
590 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
how policymakers’ credibility might aect the cost of reducing ination.
CONTEXT AND PURPOSE:
Chapter 35 is the @nal chapter in a three-chapter sequence on the economy’s short-run
uctuations around its long-term trend. Chapter 33 introduced aggregate supply and
aggregate demand. Chapter 34 developed how monetary and @scal policies aect aggregate
demand. Both Chapters 33 and 34 addressed the relationship between the price level and
output. Chapter 35 will concentrate on a similar relationship between ination and
unemployment.
The purpose of Chapter 35 is to trace the history of economists’ thinking about the
relationship between ination and unemployment. Students will see why there is a
temporary trade-o between ination and unemployment, and why there is no permanent
trade-o. This result is an extension of the results produced by the model of aggregate
supply and aggregate demand where a change in the price level induced by a change in
aggregate demand temporarily alters output but has no permanent impact on output.
KEY POINTS:
The Phillips curve describes a negative relationship between ination and
unemployment. By expanding aggregate demand, policymakers can choose a point on
the Phillips curve with higher ination and lower unemployment. By contracting
aggregate demand, policymakers can choose a point on the Phillips curve with lower
ination and higher unemployment.
The trade-o between ination and unemployment described by the Phillips curve holds
only in the short run. In the long run, expected ination adjusts to changes in actual
ination, and the short-run Phillips curve shifts. As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
The short-run Phillips curve also shifts because of shocks to aggregate supply. An
adverse supply shock, such as an increase in world oil prices, gives policymakers a less
favorable trade-o between ination and unemployment. That is, after an adverse
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  591
supply shock, policymakers have to accept a higher rate of ination for any given rate of
unemployment, or a higher rate of unemployment for any given rate of ination.
When the Fed contracts growth in the money supply to reduce ination, it moves the
economy along the short-run Phillips curve, which results in temporarily high
unemployment. The cost of disination depends on how quickly expectations of ination
fall. Some economists argue that a credible commitment to low ination can reduce the
cost of disination by inducing a quick adjustment of expectations.
CHAPTER OUTLINE:
I. The Phillips Curve
A. Origins of the Phillips Curve
1. In 1958, economist A. W. Phillips published an article discussing the negative
correlation between ination rates and unemployment rates in the United
Kingdom.
2. American economists Paul Samuelson and Robert Solow showed a similar
relationship between ination and unemployment for the United States two years
later.
3. The belief was that low unemployment is related to high aggregate demand, and
high aggregate demand puts upward pressure on prices. Likewise, high
unemployment is related to low aggregate demand, and low aggregate demand
pulls price levels down.
4. De@nition of Phillips curve: a curve that shows the short-run trade-o.
between in0ation and unemployment.
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592 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
5. Samuelson and Solow believed that the Phillips curve oered policymakers a
menu of possible economic outcomes. Policymakers could use monetary and
@scal policy to choose any point on the curve.
B. Aggregate Demand, Aggregate Supply, and the Phillips Curve
1. The Phillips curve shows the combinations of ination and unemployment that
arise in the short run as shifts in the aggregate-demand curve move the economy
along the short-run aggregate-supply curve.
2. The greater the aggregate demand for goods and services, the greater the
economy’s output and the higher the price level. Greater output means lower
unemployment. The higher the price level in the current year, the higher the rate
of ination.
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on a password-protected website or school-approved learning management system for classroom use.
Figure 1
Show how the Phillips curve is derived from the aggregate
demand/aggregate supply model step by step. This graph is dierent from
all the other graphs that they have drawn in macroeconomics, because it
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  593
3. Example: The price level is 100 (measured by the Consumer Price Index) in the
year 2020. There are two possible changes in the economy for the year 2021: a
low level of aggregate demand or a high level of aggregate demand.
a. If the economy experiences a low level of aggregate demand, we would be at
a short-run equilibrium like point A. This point also corresponds with point A on
the Phillips curve. Note that when aggregate demand is low, the ination rate
is relatively low and the unemployment rate is relatively high.
b. If the economy experiences a high level of aggregate demand, we would be at
a short-run equilibrium like point B. This point also corresponds with point B
on the Phillips curve. Note that when aggregate demand is high, the ination
rate is relatively high and the unemployment rate is relatively low.
4. Because monetary and @scal policies both shift the aggregate-demand curve,
these policies can move the economy along the Phillips curve.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Figure 2
594 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
a. Increases in the money supply, increases in government spending, or
decreases in taxes all increase aggregate demand and move the economy to
a point on the Phillips curve with lower unemployment and higher ination.
b. Decreases in the money supply, decreases in government spending, or
increases in taxes all lower aggregate demand and move the economy to a
point on the Phillips curve with higher unemployment and lower ination.
II. Shifts in the Phillips Curve: The Role of Expectations
A. The Long-Run Phillips Curve
1. In 1968, economist Milton Friedman argued that monetary policy is only able to
choose a combination of unemployment and ination for a short period of time. At
the same time, economist Edmund Phelps wrote a paper suggesting the same
thing.
2. In the long run, monetary growth has no real eects. This implies that it cannot
aect the factors that determine the economy’s long-run unemployment rate.
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on a password-protected website or school-approved learning management system for classroom use.
Figure 3
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  595
3. Thus, in the long run, we would not expect there to be a relationship between
unemployment and ination. This must mean that, in the long run, the Phillips
curve is vertical.
4. The vertical Phillips curve occurs because, in the long run, the aggregate supply
curve is vertical as well. Thus, increases in aggregate demand lead only to
changes in the price level and have no eect on the economy’s level of output.
Thus, in the long run, unemployment will not change when aggregate demand
changes, but ination will.
5. The long-run aggregate-supply curve occurs at the economy’s natural level of
output. This means that the long-run Phillips curve occurs at the natural rate of
unemployment.
B. The Meaning of “Natural”
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Figure 4
You may want to review what is meant by the “natural rate” of
unemployment.
596 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
1. Friedman and Phelps considered the natural rate of unemployment to be the rate
toward which the economy gravitates in the long run.
2. The natural rate of unemployment may not be the socially desirable rate of
unemployment.
3. The natural rate of unemployment may change over time.
C. Reconciling Theory and Evidence
1. The conclusion of Friedman and Phelps that there is no long-run trade-o between
ination and unemployment was based on theory, while the correlation between
ination and unemployment found by Phillips, Samuelson, and Solow was based
on actual evidence.
2. Friedman and Phelps believed that an inverse relationship between ination and
unemployment exists in the short run.
3. The long-run aggregate-supply curve is vertical, indicating that the price level
does not inuence output in the long run.
4. But, the short-run aggregate-supply curve is upward sloping because of
misperceptions about relative prices, sticky wages, and sticky prices. These
perceptions, wages, and prices adjust over time, so that the positive relationship
between the price level and the quantity of goods and services supplied occurs
only in the short run.
5. This same logic applies to the Phillips curve. The trade-o between ination and
unemployment holds only in the short run.
6. The expected level of ination is an important factor in understanding the
dierence between the long-run and the short-run Phillips curves. Expected
ination measures how much people expect the overall price level to change.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  597
7. The expected rate of ination is one variable that determines the position of the
short-run aggregate-supply curve. This is true because the expected price level
aects the perceptions of relative prices that people form and the wages and
prices that they set.
8. In the short run, expectations are somewhat @xed. Thus, when the Fed increases
the money supply, aggregate demand increases along the upward sloping
short-run aggregate-supply curve. Output grows (unemployment falls) and the
price level rises (ination increases).
9. Eventually, however, people will respond by changing their expectations of the
price level. Speci@cally, they will begin expecting a higher rate of ination.
D. The Short-Run Phillips Curve
1. We can relate the actual unemployment rate to the natural rate of
unemployment, the actual ination rate, and the expected ination rate using the
following equation:
a. Because expected ination is already given in the short run, higher actual
ination leads to lower unemployment.
b. How much unemployment changes in response to a change in ination is
determined by the variable a, which is related to the slope of the short-run
aggregate-supply curve.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Be sure to discuss why actual ination always equals expected ination
along the long-run Phillips curve.
unemp. rate natural rate (actual ination expected ination)a= – –
Figure 5
598 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
2. If policymakers want to take advantage of the short-run trade-o between
unemployment and ination, it may lead to negative consequences.
a. Suppose the economy is at point A and policymakers wish to lower the
unemployment rate. Expansionary monetary policy or @scal policy is used to
shift aggregate demand to the right. The economy moves to point B, with a
lower unemployment rate and a higher rate of ination.
b. Over time, people get used to this new level of ination and raise their
expectations of ination. This leads to an upward shift of the short-run Phillips
curve. The economy ends up at point C, with a higher ination rate than at
point A, but the same level of unemployment.
E. The Natural Experiment for the Natural-Rate Hypothesis
1. De@nition of the natural-rate hypothesis: the claim that unemployment
eventually returns to its normal, or natural rate, regardless of the rate
of in0ation.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 6
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  599
2. Figure 6 shows the unemployment and ination rates from 1961 to 1968. It is
easy to see the inverse relationship between these two variables.
3. Beginning in the late 1960s, the government followed policies that increased
aggregate demand.
a. Government spending rose because of the Vietnam War.
b. The Fed increased the money supply to try to keep interest rates down.
4. As a result of these policies, the ination rate remained fairly high. However, even
though ination remained high, unemployment did not remain low.
a. Figure 7 shows the unemployment and ination rates from 1961 to 1973. The
simple inverse relationship between these two variables began to disappear
around 1970.
b. Ination expectations adjusted to the higher rate of ination and the
unemployment rate returned to its natural rate of around 5% to 6%.
III. Shifts in the Phillips Curve: The Role of Supply Shocks
A. In 1974, OPEC increased the price of oil sharply. This increased the cost of producing
many goods and services and therefore resulted in higher prices.
1. De@nition of supply shock: an event that directly alters 4rms’ costs and
prices, shifting the economy’s aggregate-supply curve and thus the
Phillips curve.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 7
600 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
2. Graphically, we could represent this supply shock as a shift in the short-run
aggregate-supply curve to the left.
3. The decrease in equilibrium output and the increase in the price level left the
economy with stagation.
B. Given this turn of events, policymakers are left with a less favorable short-run
trade-o between unemployment and ination.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Price
Level
Outpu
t
Unemployment
In0atio
n
AD
AS1
AS2
PC2
PC1
Figure 8
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  601
1. If they increase aggregate demand to @ght unemployment, they will raise
ination further.
2. If they lower aggregate demand to @ght ination, they will raise unemployment
further.
C. This less favorable trade-o between unemployment and ination can be shown by a
shift of the short-run Phillips curve. The shift may be permanent or temporary,
depending on how people adjust their expectations of ination.
D. During the 1970s, the Fed decided to accommodate the supply shock by increasing
the supply of money. This increased the level of expected ination. Figure 9 shows
ination and unemployment in the United States during the late 1970s and early
1980s.
IV. The Cost of Reducing Ination
A. The Sacri@ce Ratio
1. To reduce the ination rate, the Fed must follow contractionary monetary policy.
a. When the Fed slows the rate of growth of the money supply, aggregate
demand falls.
b. This reduces the level of output in the economy, increasing unemployment.
c. The economy moves from point A along the short-run Phillips curve to point B,
which has a lower ination rate but a higher unemployment rate.
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Figure 9
602 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
d. Over time, people begin to adjust their ination expectations downward and
the short-run Phillips curve shifts. The economy moves from point B to point C,
where ination is lower and the unemployment rate is back to its natural rate.
2. Therefore, to reduce ination, the economy must suer through a period of high
unemployment and low output.
3. De@nition of sacri4ce ratio: the number of percentage points of annual
output lost in the process of reducing in0ation by one percentage point.
4. A typical estimate of the sacri@ce ratio is @ve. This implies that for each
percentage point ination is decreased, output falls by 5%.
B. Rational Expectations and the Possibility of Costless Disination
1. De@nition of rational expectations: the theory according to which people
optimally use all the information they have, including information about
government policies, when forecasting the future.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Figure 10
Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  603
2. Proponents of rational expectations believe that when government policies
change, people alter their expectations about ination.
3. Therefore, if the government makes a credible commitment to a policy of low
ination, people would be rational enough to lower their expectations of ination
immediately. This implies that the short-run Phillips curve would shift quickly
without any extended period of high unemployment.
C. The Volcker Disination
1. Figure 11 shows the ination and unemployment rates that occurred while Paul
Volcker worked at reducing the level of ination during the 1980s.
2. As ination fell, unemployment rose. In fact, the United States experienced its
deepest recession since the Great Depression.
3. Some economists have oered this as proof that the idea of a costless disination
suggested by rational-expectations theorists is not possible. However, there are
two reasons why we might not want to reject the rational-expectations theory so
quickly.
a. The cost (in terms of lost output) of the Volcker disination was not as large as
many economists had predicted.
b. While Volcker promised that he would @ght ination, many people did not
believe him. Few people thought that ination would fall as quickly as it did;
this likely kept the short-run Phillips curve from shifting quickly.
D. The Greenspan Era
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Figure 11
Figure 12
604 ❖ Chapter 35/The Short-Run Trade-o between Ination and Unemployment
1. Figure 12 shows the ination and unemployment rate from 1984 to 2005, called
the Greenspan era because Alan Greenspan became the chair of the Federal
Reserve in 1987.
2. In 1986, OPEC’s agreement with its members broke down and oil prices fell. The
result of this favorable supply shock was a drop in both ination and
unemployment.
3. The rest of the 1990s witnessed a period of economic prosperity. Ination
gradually dropped, approaching zero by the end of the decade. Unemployment
also reached a low level, leading many people to believe that the natural rate of
unemployment had fallen.
4. The economy ran into problems in 2001 due to the end of the dot-com stock
market bubble, the 9-11 terrorist attacks, and corporate accounting scandals that
reduced aggregate demand. Unemployment rose as the economy experienced its
@rst recession in a decade.
5. But a combination of expansionary monetary and @scal policies helped end the
downturn, and by early 2005, the unemployment rate was close to the estimated
natural rate.
6. In 2005, President Bush nominated Ben Bernanke as the Fed chair.
E. A Financial Crisis Takes Us for a Ride Along the Phillips Curve
1. In his @rst couple of years as Fed chair, Bernanke faced some signi@cant
economic challenges.
a. One challenge arose from problems in the housing and @nancial markets.
b. The resulting @nancial crisis led to a large drop in aggregate demand and high
rates of unemployment.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Chapter 35/The Short-Run Trade-o between Ination and Unemployment ❖  605
c. Figure 13 shows the implications of these events for ination and
unemployment.
d. From 2007 to 2010, as the decline in aggregate demand raised unemployment
from below 5 percent to about 10 percent, it also reduced the ination rate
from about 3 percent to about 1 percent.
e. From 2010 to 2015, unemployment fell back to about 5 percent and the
ination rate remained between 1 percent and 2 percent.
f. In essence, the economy @rst rode down the Phillips curve and then rode back
up.
g. Note that expected ination and the position of the short-run Phillips curve
were relatively stable during this period.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Figure 13