The Short-Run Tradeoff between Inflation and Unemployment

Transcription

1 The Short-Run Tradeoff between and Chapter 33 Copyright 1 by Harcourt, Inc. ll rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 77 Sea Harbor Drive, Orlando, Florida and u The natural rate of depends on various features of the labor market. u Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. and u The rate depends primarily on growth in the quantity of money, controlled by the Fed. u The misery index, one measure of the health of the economy, adds together the rate and rate. 1

2 and u Society faces a short-run tradeoff between and. u If policymakers expand aggregate demand, they can lower, but only at the cost of higher. u If they contract aggregate demand, they can lower, but at the cost of temporarily higher. The Phillips Curve The illustrates the short-run relationship between and. The Phillips Curve... (percent per year) 7 (percent)

3 ggregate Demand, ggregate Supply, and the Phillips Curve u The shows the short-run combinations of and that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. ggregate Demand, ggregate Supply, and the Phillips Curve u The greater the aggregate demand for goods and services, the greater is the economy s output, and the higher is the overall price level. u higher level of output results in a lower level of. How the Phillips Curve is Related to the Model of ggregate Demand and ggregate Supply... (a) The Model of D and S (b) The Phillips Curve Price Level 7,5 ( is 7%) Short-run S Low D (percent per year) High D, ( is 7%) 7 (output is (output is,) 7,5) (percent) 3

4 Shifts in the Phillips Curve: The Role of Expectations The seems to offer policymakers a menu of possible and outcomes. The Long-Run Phillips Curve u In the 19s, Friedman and Phelps concluded that and are unrelated in the long run. u s a result, the long-run is vertical at the natural rate of. u Monetary policy could be effective in the short run but not in the long run. The Long-Run Phillips Curve When the Fed increases the growth rate of the money supply, the rate of increases High Low Natural rate of Long-run. but remains at its natural rate in the long run.

5 How the Phillips Curve is Related to the Model of ggregate Demand and ggregate Supply (a) The Model of ggregate Demand and ggregate Supply Price Level P Long-run aggregate supply 1. n increase in the money supply increases aggregate demand (b) The Phillips Curve Long-run Phillips curve 3. and increases the rate P 1. raises the price level Natural rate of output D ggregate demand, D 1 Quantity of Output Natural rate of. but leaves output and at their natural rates. Expectations and the Short-Run Phillips Curve Expected measures how much people expect the overall price level to change. Expectations and the Short-Run Phillips Curve u In the long run, expected adjusts to changes in actual. u The Fed s ability to create unexpected exists only in the short run. u Once people anticipate, the only way to get below the natural rate is for actual to be above the anticipated rate. 5

6 Expectations and the Short-Run Phillips Curve = Natural rate of - a( - ) ctual Expected This equation relates the rate to the natural rate of, actual, and expected. How Expected Shifts the Short-Run Phillips Curve... Long-run 1. Expansionary policy moves the economy up along the shortrun Phillips curve... Natural rate of C. but in the long-run, expected rises, and the short-run Phillips curve shifts to the right. Short-run with high expected Short-run with low expected The Natural- Hypothesis u The view that eventually returns to its natural rate, regardless of the rate of, is called the natural-rate hypothesis. u Historical observations support the natural-rate hypothesis.

7 The Natural Experiment for the Natural Hypothesis u The concept of a stable broke down in the in the early 7s. u During the 7s and s, the economy experienced high and high simultaneously. The Phillips Curve in the 19s (percent) The reakdown of the Phillips Curve (percent) 7

8 Shifts in the Phillips Curve: The Role of Supply Shocks u Historical events have shown that the short-run can shift due to changes in expectations. Shifts in the Phillips Curve: The Role of Supply Shocks u The short-run also shifts because of shocks to aggregate supply. u Major adverse changes in aggregate supply can worsen the short-run tradeoff between and. u n adverse supply shock gives policymakers a less favorable tradeoff between and. Shifts in the Phillips Curve: The Role of Supply Shocks u supply shock is an event that directly affects firms costs of production and thus the prices they charge. u It shifts the economy s aggregate supply curve... u and as a result, the.

9 n dverse Shock to ggregate Supply... Price Level (a) The Model of ggregate Demand and ggregate Supply 3. and raises the price level S ggregate supply, S 1 (b) The Phillips Curve. giving policymakers a less favorable tradeoff between and. P P 1 Y Y 1. lowers output 1. n adverse shift in aggregate supply ggregate demand Quantity of Output PC, PC 1 Shifts in the Phillips Curve: The Role of Supply Shocks u In the 197s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. u Fight the battle by expanding aggregate demand and accelerate. u Fight by contracting aggregate demand and endure even higher. The Supply Shocks of the 197s (percent) 9

10 The Cost of Reducing u To reduce, the Fed has to pursue contractionary monetary policy. u When the Fed slows the rate of money growth, it contracts aggregate demand. u This reduces the quantity of goods and services that firms produce. u This leads to a rise in. Long-run Disary Monetary Policy in the Short Run and the Long Run Contractionary policy moves the economy down along the short-run... C Natural rate of Short-run with high expected Short-run with low expected.... but in the long run, expected falls and the short-run shifts to the left. The Cost of Reducing u To reduce, an economy must endure a period of high and low output. u When the Fed combats, the economy moves down the short-run Phillips curve. u The economy experiences lower but at the cost of higher.

11 The Cost of Reducing u The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing by one percentage point. u n estimate of the sacrifice ratio is five. u To reduce from about % in to % would have required an estimated sacrifice of 3% of annual output! Rational Expectations The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. Rational Expectations u Expected explains why there is a tradeoff between and in the short run but not in the long run. u How quickly the short-run tradeoff disappears depends on how quickly expectations adjust. 11

12 Rational Expectations u The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated. The Volcker Dis u When Paul Volcker was Fed chairman in the 197s, was widely viewed as one of the nation s foremost problems. u Volcker succeeded in reducing (from % to %), but at the cost of high employment (about % in 193). The Volcker Dis C (percent) 1

13 The Greenspan Era u lan Greenspan s term as Fed chairman began with a favorable supply shock. u In 19, OPEC members abandoned their agreement to restrict supply. u This led to falling and falling. The Greenspan Era (percent) The Greenspan Era u Fluctuations in and in recent years have been relatively small due to the Fed s actions. 13

14 Summary u The describes a negative relationship between and. u y expanding aggregate demand, policymakers can choose a point on the with higher and lower. u y contracting aggregate demand, policymakers can choose a point on the with lower and higher. Summary u The tradeoff between and described by the Phillips curve holds only in the short run. u The long-run is vertical at the natural rate of. Summary u The short-run also shifts because of shocks to aggregate supply. u n adverse supply shock gives policymakers a less favorable tradeoff between and. 1

15 Summary u When the Fed contracts growth in the money supply to reduce, it moves the economy along the short-run. u This results in temporarily high. u The cost of dis depends on how quickly expectations of fall. Summary u ecause monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy. u Changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment. Graphical Review 15

16 The Phillips Curve... (percent per year) 7 (percent) How the Phillips Curve is Related to the Model of ggregate Demand and ggregate Supply... (a) The Model of D and S (b) The Phillips Curve Price Level 7,5 ( is 7%) Short-run S Low D (percent per year) High D, ( is 7%) 7 (output is (output is,) 7,5) (percent) The Long-Run Phillips Curve When the Fed increases the growth rate of the money supply, the rate of increases High Low Natural rate of Long-run. but remains at its natural rate in the long run. 1

17 How the Phillips Curve is Related to the Model of ggregate Demand and ggregate Supply (a) The Model of ggregate Demand and ggregate Supply Price Level P Long-run aggregate supply 1. n increase in the money supply increases aggregate demand (b) The Phillips Curve Long-run Phillips curve 3. and increases the rate P 1. raises the price level Natural rate of output D ggregate demand, D 1 Quantity of Output Natural rate of. but leaves output and at their natural rates. How Expected Shifts the Short-Run Phillips Curve... Long-run 1. Expansionary policy moves the economy up along the shortrun Phillips curve... Natural rate of C. but in the long-run, expected rises, and the short-run Phillips curve shifts to the right. Short-run with high expected Short-run with low expected The Phillips Curve in the 19s (percent) 17

18 The reakdown of the Phillips Curve (percent) n dverse Shock to ggregate Supply... Price Level (a) The Model of ggregate Demand and ggregate Supply 3. and raises the price level S ggregate supply, S 1 (b) The Phillips Curve. giving policymakers a less favorable tradeoff between and. P P 1 Y Y 1. lowers output 1. n adverse shift in aggregate supply ggregate demand Quantity of Output PC, PC 1 The Supply Shocks of the 197s (percent) 1

19 Disary Monetary Policy in the Short Run and the Long Run... Long-run 1. Contractionary policy moves the economy down along the short-run... C Natural rate of Short-run with high expected Short-run with low expected.... but in the long run, expected falls and the short-run shifts to the left. The Volcker Dis C (percent) The Greenspan Era (percent) 19