In this video we’ll explore the trade-off between inflation and unemployment.
We will use the short-run and long-run Phillips curve to explore the relationship further.
The trade-off between unemployment and inflation comes from the fact that measures to boost
aggregate demand may cause output and employment to increase as well as place upward pressure
on wages and resources.
If aggregate demand increases and more people are working, this can lead to demand-pull
inflation.
Overall, unemployment will fall and inflation may rise.
I’ve taken two snapshots from Federal Reserve Bank data on the unemployment rate and inflation.
On top is the unemployment rate and the bottom graph is the rate of inflation.
The shaded areas represent US recessions.
You can see that unemployment often spikes in recessions or just after.
As unemployment rises, you can also typically see inflation falling.
This covers from just before 1950 to recent times.
The data helps to demonstrate the relationship between unemployment and inflation as measured
by consumer prices.
It should also follow then that measures to decrease aggregate demand may cause output
and employment to decrease as well as place downward pressure on wages.
Additionally, it may also result in a fall in the price level.
Unemployment will rise and inflation may decrease.
If there is a negative supply-shock to the economy, such as a sudden rise in oil prices,
this can lead to stagflation.
Higher costs will result in lower output and higher unemployment.
The economy will suffer from both higher prices and higher unemployment.
Now let’s turn to the Phillips Curve model to understand the relationship between unemployment
and inflation visually.
The Phillips curve was developed by New Zealand Economist A.W.
Phillips.
The basis of the model is that unemployment and inflation have a stable and inverse relationship.
As the unemployment rate increases, the rate of inflation falls.
We label the curve, SRPC and call it the short-run Phillips curve.
The Phillips Curve presents policymakers with combinations to target.
For example, the red combination of U1I1 demonstrates a point at which unemployment is very low
but the rate of inflation is high.
On the other side, the green combination U2I2 represents a point at which unemployment is
very high but the rate of inflation is very low.
Now, enter Milton Friedman and Edmund Phelps who challenged this model and said that the
government would not be able to permanently lower unemployment at a high rate of inflation.
Rather, they argued, inflationary expectations would lead workers to ask for higher wages
and in the long-run the economy would return to the natural rate of unemployment.
To Friedman, the long-run Phillips curve or the expectations-augmented Phillips curve
was a vertical line at the natural rate of unemployment or NRU in this graph.
To understand why this is, let’s review the classical aggregate demand and aggregate
supply model.
You’ll recall that in the classical view of economics, the long-run aggregate supply
curve is vertical at the natural rate of unemployment which we will call Y* in the graph on the
left.
Now let’s bring in our aggregate demand and short-run aggregate supply curves.
As you can see our economy is currently in short-run and long-run equilibrium at PL*.
If there is a sudden rise in aggregate demand, the aggregate demand curve will shift rightwards
from AD to AD1.
This now corresponds to an increase in output from Y* to Y1 and an increase in the price
level from PL* to PL1.
Classical economists argue that in the face of inflation, workers expect prices to increase
and thus increase their wage demands.
This causes an increase in production costs and shifts the short-run aggregate supply
curve leftward which returns us back to the natural rate of unemployment at Y* at a higher
price level PL2.
Let’s connect this to the short-run and long-run Phillips curves.
I’ll use straight lines for the short-run Phillips curve for the sake of simplicity.
The price level PL* can be taken across and changed to I1 for the Phillips Curve model.
We know that unemployment is at the natural rate and that corresponds to an inflation
rate of I1.
To make it easier to follow, I’ll use the same color dots to indicate relationships.
As a result of the increase in aggregate demand, from AD to AD1 output rises from Y* to Y1
and unemployment falls.
The price level increases from PL* to PL1.
We take this across to the Phillips Curve as well for an inflation rate of I2.
Any shift of AD along the original SRAS curve can be demonstrated as follows.
The blue dots appearing on the diagram on the left correspond to their matching blue
dot on the short-run Phillips Curve on the right.
Now let’s see what happens when inflationary expectations cause the short-run aggregate
supply curve to shift leftwards from SRAS to SRAS1.
The new price level is PL2 and real GDP returns to Y* which corresponds to the natural rate
of unemployment.
We return to the long-run Phillips curve at the natural rate of unemployment at a higher
rate of inflation, I3.
Let’s see what would happen if aggregate demand shifted along any points of short-run
aggregate supply curve 1.
Again, the corresponding points will match on both diagrams.
Those three dots look strange standing alone.
However, when we see a shift in aggregate supply we also see that the short-run Phillips
curve also shifts – almost like a mirror image.
If the short-run aggregate supply curve shifts leftward, the short-run Phillips curve shifts
rightwards.
Now let’s look at animation that brings it all together again.
We begin at the natural rate of unemployment or Y* on the AD AS diagram.
This corresponds to I1 and the NRU with the original short-run phillips curve.
When aggregate demand shifts from AD to AD1, output increases from Y* to Y1 and the price
level increases from PL* to PL1.
On SRPC we demonstrate this reduction in unemployment and increase in the inflation rate with point
I2U1.
Inflationary expectations cause the short-run aggregate supply curve to shift leftwards
from SRAS to SRAS1.
As a result the price level increases from PL1 to PL2 and output returns to Y*.
This is mirrored by the short-run Phillips curve as it shifts from SRPC to SRPC1 and
the economy returns to the natural rate of unemployment at a new inflation rate of I3.
The short-run Phillips curve shift also helps us understand the impact of stagflation.
As short run aggregate supply shifts leftwards and decreases it leads to higher prices AND
higher unemployment.
We see this in the shift of SRPC to SRPC1 and the corresponding increase in the inflation
rate from I2 to I3 alongside the increase in unemployment from U1 to the natural rate.
Now you try it.
Let’s start the models at short-run and long-run equilibrium.
What would happen on both diagrams if there was a sudden fall in aggregate demand?
If you shifted the AD curve leftwards to AD1, you made the first correct move.
On the diagram on the right we just move along the SRPC curve to a point reflecting the corresponding
fall in the inflation rate and rise in the unemployment rate.
But we’re not done yet.
If AD falls and the price level decreases, demonstrate the impact of the expectations
of workers on both diagrams.
If you’ve done this correctly, you shifted the SRAS curve rightwards to SRAS1, returning
to the level of output Y* at a lower price level.
You should also have shifted your short-run phillips curve leftward to SRPC1.
If I add in all the labels to make it clearer, this is what the final solution would look
like.
If your answer doesn’t look the same, leave a comment below and let’s try and figure
it out.
Now you should have a better understanding of the trade off between inflation and unemployment.
If you’ve become comfortable with the short-run and long-run Phillips curve then you are doing
very well.
If you have any questions or comments, leave them below and let’s see if we can address
them as a community.
That’s us done for now and I will see you in the next one!