Academia de Studii Economice

Facultatea: Cibernetica, Statistica si Informatica Economica

Specializarea: Informatica economica (cu predare in engleza)

Macroeconomics Project

Inflation and Unemployment

Students:
Negreanu Radu
Pitis Radu
Group 1052

Bucharest
2018
In economics, inflation is a sustained increase in price level of goods and
services in an economy over a period of time. When the price level rises, each
unit of currency buys fewer goods and services; consequently, inflation reflects
a reduction in the purchasing power per unit of money – a loss of real value in
the medium of exchange and unit of account within the economy. A chief
measure of price inflation is the inflation rate, the annualized percentage change
in a general price index, usually the consumer price index, over time. The
opposite of inflation is deflation.

Inflation affects economies in various positive and negative ways. The negative
effects of inflation include an increase in the opportunity cost of holding money,
uncertainty over future inflation which may discourage investment and savings,
and if inflation were rapid enough, shortages of goods as consumers begin
hoarding out of concern that prices will increase in the future. Positive effects
include reducing the real burden of public and private debt, keeping nominal
interest rates above zero so that central banks can adjust interest rates to stabilize
the economy, and reducing unemployment due to nominal wage rigidity.

Economists generally believe that high rates of inflation and hyperinflation are
caused by an excessive growth of the money supply. Views on which factors
determine low to moderate rates of inflation are more varied. Low or moderate
inflation may be attributed to fluctuations in real demand for goods and services,
or changes in available supplies such as during scarcities. However, the
consensus view is that a long sustained period of inflation is caused by money
supply growing faster than the rate of economic growth. Inflation may also lead
to an invisible tax in which the value of currency is lowered in contrast with its
actual reserve, ultimately leading individuals to hold devalued legal tender.

Today, most economists favor a low and steady rate of inflation. Low (as
opposed to zero or negative) inflation reduces the severity of economic
recessions by enabling the labor market to adjust more quickly in a downturn,
and reduces the risk that a liquidity trap prevents monetary policy from
stabilizing the economy. The task of keeping the rate of inflation low and stable
is usually given to monetary authorities.
Generally, these monetary authorities are the central banks that control monetary
policy through the setting of interest rates, through open market operations, and
through the setting of banking reserve requirements.

It has often been the case that progress against inflation comes at the expense of
greater unemployment, and that reduced unemployment comes at the expense of
greater inflation. This section looks at the record and traces the emergence of the
view that a simple trade-off between these macroeconomic “bad guys” exists.

Clearly, it is desirable to reduce unemployment and inflation. Unemployment

represents a lost opportunity for workers to engage in productive effort—and to
earn income. Inflation erodes the value of money people hold, and more
importantly, the threat of inflation adds to uncertainty and makes people less
willing to save and firms less willing to invest. If there were a trade-off between
the two, we could reduce the rate of inflation or the rate of unemployment, but
not both. The fact that the United States did make progress against
unemployment and inflation through most of the 1990s and early 2000s
represented a macroeconomic triumph, one that appeared impossible just a few
years earlier. The next section examines the argument that once dominated
macroeconomic thought—that a simple trade-off between inflation and
unemployment did, indeed, exist. The argument continues to appear in
discussions of macroeconomic policy today; it will be useful to examine it.

The Phillips Curve in the Short Run

In 1958, New Zealand–born economist Almarin Phillips reported that his
analysis of a century of British wage and unemployment data suggested that an
inverse relationship existed between rates of increase in wages and British
unemployment (Phillips, 1958). Economists were quick to incorporate this idea
into their thinking, extending the relationship to the rate of price-level
changes—inflation—and unemployment. The notion that there is a trade-off
between the two is expressed by a short-run Phillips curve, a curve that suggests
a negative relationship between inflation and unemployment. Figure 16.1 “The
Short-Run Phillips Curve” shows a short-run Phillips curve.
Figure 16.1 The Short-Run Phillips Curve
The relationship between inflation and unemployment suggested by the work of
Almarin Phillips is shown by a short-run Phillips curve.

The short-run Phillips curve seemed to make good theoretical sense. The
dominant school of economic thought in the 1960s suggested that the economy
was likely to experience either a recessionary or an inflationary gap. An
economy with a recessionary gap would have high unemployment and little or
no inflation. An economy with an inflationary gap would have very little
unemployment and a higher rate of inflation. The Phillips curve suggested a
smooth transition between the two. As expansionary policies were undertaken to
move the economy out of a recessionary gap, unemployment would fall and
inflation would rise. Policies to correct an inflationary gap would bring down
the inflation rate, but at a cost of higher unemployment.
The experience of the 1960s suggested that precisely the kind of trade-off the
Phillips curve implied did, in fact, exist in the United States. Figure 16.2 “The
Short-Run Phillips Curve in the 1960s” shows annual rates of inflation
(computed using the implicit price deflator) plotted against annual rates of
unemployment from 1961 to 1969. The points appear to follow a path quite
similar to a Phillips curve relationship. The civilian unemployment rate fell from
6.7% in 1961 to 3.5% in 1969. The inflation rate rose from 1.1% in 1961 to
4.8% in 1969. While inflation dipped slightly in 1963, it appeared that, for the
decade as a whole, a reduction in unemployment had been “traded” for an
increase in inflation.

Figure 16.2 The Short-Run Phillips Curve in the 1960s

Values of U.S. inflation and unemployment rates during the 1960s generally
conformed to the trade-off implied by the short-run Phillips curve. The points
for each year lie close to a curve with the shape that Phillips’s analysis
predicted.

In the mid-1960s, the economy moved into an inflationary gap as

unemployment fell below its natural level. The economy had already reached its
full employment level of output when the 1964 tax cut was passed. The Fed
undertook a more expansionary monetary policy at the same time. The
combined effect of the two policies increased aggregate demand and pushed the
economy beyond full employment and into an inflationary gap. Aggregate
demand continued to rise as U.S. spending for the war in Vietnam expanded and
as President Lyndon Johnson launched an ambitious program aimed at putting
an end to poverty in the United States.

By the end of the decade, unemployment at 3.5% was substantially below its
natural level, estimated by the Congressional Budget Office to be 5.6% that
year. When Richard Nixon became president in 1969, it was widely believed
that, with an economy operating with an inflationary gap, it was time to move
back down the Phillips curve, trading a reduction in inflation for an increase in
unemployment. President Nixon moved to do precisely that, serving up a
contractionary fiscal policy by ordering cuts in federal government purchases.
The Fed pursued a contractionary monetary policy aimed at bringing inflation
down.

The Short-Run Phillips Curve Goes Uneven

The effort to nudge the economy back down the Phillips curve to an
unemployment rate closer to the natural level and a lower rate of inflation met
with an unhappy surprise in 1970. Unemployment increased as expected. But
inflation rose! The inflation rate rose to 5.3% from its 1969 rate of 4.8%.
The tidy relationship between inflation and unemployment that had been
suggested by the experience of the 1960s fell apart in the 1970s. Unemployment
rose substantially, but inflation remained the same in 1971. In 1972, both rates
fell. The economy seemed to fall back into the pattern described by the Phillips
curve in 1973, as inflation rose while unemployment fell. But the next two years
saw increases in both rates. The negatively sloped Phillips curve relationship
between inflation and unemployment that had seemed to hold true in the 1960s
no longer prevailed.

Indeed, a look at annual rates of inflation and unemployment since 1961

suggests that the 1960s were quite atypical. Figure 16.3 “Inflation and
Unemployment, 1961–2011” shows the two variables over the period from 1961
through 2011. It is hard to see a negatively sloped Phillips curve lurking within
that seemingly random scatter of points.

Figure 16.3 Inflation and Unemployment, 1961–2011

Annual observations of inflation and unemployment in the United States from
1961 to 2011 do not seem consistent with a Phillips curve.

The Long-Run Phillips Curve

The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and
unemployment are unrelated in the long run.

Key Points

 The natural rate of unemployment is the hypothetical level of unemployment the economy
would experience if aggregate production were in the long-run state.
 The natural rate hypothesis, or the non-accelerating inflation rate of unemployment
(NAIRU) theory, predicts that inflation is stable only when unemployment is equal to the
natural rate of unemployment. If unemployment is below (above) its natural rate, inflation
will accelerate (decelerate).
 Expansionary efforts to decrease unemployment below the natural rate of unemployment
will result in inflation. This changes the inflation expectations of workers, who will adjust
their nominal wages to meet these expectations in the future. This leads to shifts in the
short-run Phillips curve.
 The natural rate hypothesis was used to give reasons for stagflation, a phenomenon that
the classic Phillips curve could not explain.

The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is
this relationship in the long run? According to economists, there can be no trade-off between
inflation and unemployment in the long run. Decreases in unemployment can lead to increases in
inflation, but only in the short run. In the long run, inflation and unemployment are unrelated.
Graphically, this means the Phillips curve is vertical at the natural rate of unemployment, or the
hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to
change unemployment rates only serve to move the economy up and down this vertical line.

Natural Rate Hypothesis

The natural rate of unemployment theory, also known as the non-accelerating inflation rate of
unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund
Phelps. According to NAIRU theory, expansionary economic policies will create only temporary
decreases in unemployment as the economy will adjust to the natural rate. Moreover, when
unemployment is below the natural rate, inflation will accelerate. When unemployment is above
the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate,
inflation is stable, or non-accelerating.
The reason the short-run Phillips curve shifts is due to the changes in inflation
expectations. Workers, who are assumed to be completely rational and
informed, will recognize their nominal wages have not kept pace with inflation
increases (the movement from A to B), so their real wages have been decreased.
As such, in the future, they will renegotiate their nominal wages to reflect the
higher expected inflation rate, in order to keep their real wages the same. As
nominal wages increase, production costs for the supplier increase, which
diminishes profits. As profits decline, suppliers will decrease output and employ
fewer workers (the movement from B to C). Consequently, an attempt to
decrease unemployment at the cost of higher inflation in the short run led to
higher inflation and no change in unemployment in the long run.

The NAIRU theory was used to explain the stagflation phenomenon of the
1970’s, when the classic Phillips curve could not. According to the theory, the
simultaneously high rates of unemployment and inflation could be explained
because workers changed their inflation expectations, shifting the short-run
Phillips curve, and increasing the prevailing rate of inflation in the economy. At
the same time, unemployment rates were not affected, leading to high inflation
and high unemployment.

Inflation and Unemployment Relationships Over Time

Although the points plotted in Figure 16.3 “Inflation and Unemployment, 1961–
2011” are not consistent with a negatively sloped, stable Phillips curve,
connecting the inflation/unemployment points over time allows us to focus on
various ways that these two variables may be related.

In Figure 16.4 “Connecting the Points: Inflation and Unemployment” we draw

connecting lines through the sequence of observations. By doing so, we see
periods in which inflation and unemployment are inversely related (as in the
1960s, late 1970s, late 1980s, the end of the twentieth century, and the first
decade of the 2000s). We refer to a period when inflation and unemployment are
inversely related as a Phillips phase.

During other periods, both inflation and unemployment were increasing (as from
1973 to 1975 or 1979 to 1981). A period of rising inflation and unemployment is
called a stagflation phase. Finally, a recovery phase is a period in which both
unemployment and inflation fall (as from 1975 to 1976, 1982 to 1984, and 1992
to 1998). Figure 16.5 “Inflation—Unemployment Phases” presents a stylized
version of these three phases.
Figure 16.4 Connecting the Points: Inflation and Unemployment

Connecting observed values for unemployment and inflation sequentially

suggests a cyclical pattern of clockwise loops over the 1961–2002 period, after
which we see a series of inverse relationships.
Figure 16.5 Inflation—Unemployment Phases

The figure shows the way an economy may move from a Phillips phase to a
stagflation phase and then to a recovery phase.
Trace the path of inflation and unemployment as it unfolds in Figure 16.4
“Connecting the Points: Inflation and Unemployment”. Starting with the Phillips
phase in the 1960s, we see that the economy went through three clockwise
loops, representing a stagflation phase, then a recovery phase, a Phillips phase,
and so on. Each took the United States to successively higher rates of inflation
and unemployment. Following the stagflation of the late 1970s and early 1980s,
however, something quite significant happened. The economy suffered a very
high rate of unemployment but also achieved very dramatic gains against
inflation. The recovery phase of the 1990s was the longest since the U.S.
government began tracking inflation and unemployment. Good luck explains
some of that: oil prices fell in the late 1990s, shifting the short-run aggregate
supply curve to the right. That boosted real GDP and put downward pressure on
the price level. But one cause of that improved performance seemed to be the
better understanding economists gained from some policy mistakes of the 1970s.

The 2000s look like a series of Phillips phases. The brief recession in 2001
brought higher unemployment and slightly lower inflation. Unemployment fell
from 2003 to 2006 but with slightly higher inflation each year. The Great
Recession, which began at the end of 2007, was characterized by higher
unemployment and lower inflation. The next section will explain these
experiences in a stylized way in terms of the aggregate demand and supply
model.
 Bibliography:

 http://open.lib.umn.edu
 http://wikipedia.com
 https://investopedia.com
 https://courses.lumenlearning.com