GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 10: The Short-run Tradeo Between Ination and Unemployment
Junichi Fujimoto
January 4, 2017

1 Overview
In Macro I (Chapter 7 of the textbook), you studied how the long run level of unemployment rate (or the natural
rate of unemployment) is determined. We now explore the short run deviation of unemployment from the natural
rate. This requires reviewing the derivation of the SRAS curve.
Before looking at the models, let us state an important empirical relationship between unemployment and GDP.
Since unemployed workers do not engage in production of goods and services, increases in unemployment should be
associated with decreases in real GDP. Such negative relationship between unemployment and real GDP is called
Okun's law. Textbook p286, Figure 10-4 depicts this relationship in the U.S. data; it is a scatterplot of the change
in the unemployment rate on the horizontal axis, and the percentage change in real GDP on the vertical axis. The
magnitude of this relationship is expressed as
Percentage Change in Real GDP = 3% 2 Change in the Unemployment Rate.
Thus, if there is no changes to the unemployment rate, real GDP grows by about 3 percent per year due to
growth in the labor force, capital accumulation, and technological progress. For every percentage point rise in the
unemployment rate, real GDP growth typically falls by 2 percent.

2 Models of Aggregate Supply

2.1 Overview
In Lecture Note 2, we studied the model of short-run aggregate supply featuring sticky wages due to labor contracts.
Let us study here two alternative models of aggregate supply.
In any of these models, the output of the economy may deviate from its long-run level due to some market
imperfection (or friction), giving rise to the SRAS curve of the following form:
Y = Y + (P EP ), > 0.

(1)

Here, Y is output, Y is the natural level of output, P is the price level, and EP is the expected price level (To be
precise, it is better to consider these as the natural log of the original variables; we will come back to this issue in
Section 3).

2.2 The Imperfect-Information Model

The imperfect-information model assumes that prices are exible, such that all markets clear. In this model,
however, suppliers of each good monitor closely the price of what they produce, but less closely all other goods.
Thus, when the overall level of prices rises, individual supplier confuses this as the rise in the relative price of the
goods he produces to other goods, and increase supply of goods. Since all suppliers follow the same behavior, output
of the economy is increasing in the price level, hence the SRAS curve is expressed as (1).
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2.3 The sticky-price model

The sticky-price model emphasizes that rms do not adjust prices immediately in responses to change in demand.
Prices may be set by long-term contracts between rms and customers, or rms may choose to hold prices to
avoid annoying their customers by frequent price changes. The costs of reprinting catalogs or price lists may also
discourage rms from changing prices.
The sticky-price model assumes monopolistic competition, instead of perfect competition. Thus, instead of
taking prices as given, rms have some monopolistic control over the price they charge. A typical rm's desired
price p depends on the overall price level P and the level of aggregate income Y . A higher price level implies higher
costs of production, so the rm wishes to charge a higher price. A higher level of income raises the demand for the
rm's product, and increases the marginal cost, so the rm wishes to charge more. The rm's desired price can
thus be written as
(2)
Assume that there are two types of rms. First type of rms have exible prices, and set prices according to
(2). Second type of rms have sticky prices, and set prices in advance based on the expectation of future economic
conditions. That is,
p = P + a(Y Y ), a > 0.

p = EP + a(EY E Y ),
(3)
where EP , EY , and E Y are expected values of P , Y , and Y . For simplicity, let us assume EY = E Y . Then, the

second group of rms set the price

p = EP.

(4)

Thus, rms with sticky prices set prices based on the expectation of the prices set by other rms.
The overall price level in the economy is the weighted average of the prices set by two groups. Let s be the
fraction of rms with sticky prices, and 1 s be the fraction of rms with exible prices. Then, the overall price
level is
P = sEP + (1 s){P + a(Y Y )}.
(5)
Solving this for P , we obtain
(1 s)a
(Y Y ).
(6)
P = EP +
s

This equation can be explained as follows. When rms expect a high price level, sticky prices rms set high prices
since they expect high costs. This causes the other rms to set high prices, which leads to high P . When output is
high, exible prices rms set high prices since the demand for goods is high, which again increases P . This eect
is stronger with a higher fraction of exible prices rms.
Rearranging (6), we obtain the familiar expression
Y = Y + (P EP ),

where =

s
(1s)a

> 0.

2.4 Summary and Implications

In all three models of aggregate supply we have studied, the SRAS curve is expressed as
Y = Y + (P EP ).

That is, output exceeds the natural level if the actual price level exceeds the expected price level, and output falls
below the natural level when the actual price level turns out to be lower than its expected value. Thus, the SRAS
curve is upward sloping, as shown in Figure 1.
Let us examine the eects of an unexpected rise in the aggregate demand. Suppose that in Figure 2, the economy
is initially at point A, which corresponds to the long run equilibrium. Suppose now the AD curve shifts from AD1
to AD2 . Then, the price level exceeds its expected value EP2 , so the economy moves along SRAS1 to point B,
and output temporarily exceeds the natural level. However, in the long run, the expected price level catches up
with the actual price level, and shifts the SRAS curve to SRAS2 . Thus, the expected price level rises to EP3 , and
the equilibrium moves to point C. The actual price level rises from P2 to P3 , and output falls from Y2 to Y3 (= Y ).
Thus, while money is not neutral in the short run, it is so in the long run.
2

LRAS

SRAS
Y = Y + ( P EP)

EP

Figure 1: The SRAS Curve

3 The Phillips Curve

3.1 The SRAS Curve and The Phillips Curve
Rearranging the expression for the SRAS curve (1) and adding supply shocks term , we obtain
P = EP +

1
(Y Y ) + .

(7)

Subtracting the price level of the previous year, P1 , from both sides,
(P P1 ) = (EP P1 ) +

1
(Y Y ) + .

(8)

As mentioned in Section 2.1, it is more appropriate to interpret the price levels and output as denoting the
natural log of the original variable, so let us interpret as such. Then, (8) can be rewritten, using the ination rate
and the rate of expected ination E , as
= E +

1
(Y Y ) + .

Finally, let us recall Okun's law discussed in Section 1. One formulation of Okun's law is that the (percentage)
deviation of output from its natural level, Y Y , is negatively related to the deviation of the unemployment rate
from its natural level, that is,
1
(Y Y ) = (u un ).

Combining these, we obtain the Phillips curve equation,

= E (u un ) + .

(9)

The Phillips curve equation implies that the deviation of the ination rate from its natural level, E , is negatively
related to the deviation of unemployment from its natural rate, u un . In other words, it expresses the tradeo
between unemployment and ination.
The Phillips curve, as originally proposed by A. W. Phillips, indicated the negative relation between the unemployment rate and the rate of wage ination. The modern Phillips curve diers from its original formulation in
three regards. It considers price ination instead of wage ination, it includes expected ination, and it includes
supply shocks.
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LRAS

SRAS 2
C
P3 = EP3

SRAS 1
B

P2

P1 = EP1 = EP2
A

AD2
AD1

Y1 = Y3 = Y

Y2

Figure 2: Unexpected Rise in Aggregate Demand

3.2 Adaptive Expectations and Ination Inertia

To make the Phillips curve a useful tool for policy analysis, we need to specify what determines expected ination.
Adaptive expectation is an assumption that people form their expectations of ination based on recently observed
ination, or
E = 1 .
(10)
In this case, the Phillips curve can be rewritten as
= 1 (u un ) + .

(11)

This equation implies that ination depends on past ination, cyclical unemployment, and supply shocks. When
the Phillips curve is written in this form, the natural rate of unemployment is sometimes called the non-accelerating
ination rate of unemployment (NAIRU).
The rst term in (11), 1 , implies that ination has inertia. That is, if unemployment is at the NAIRU, and if
there are no supply shocks, the ination rate equals the past ination rate. Such inertia arises since past ination
aects expectation of future ination, which in turn inuences wages and prices.
In the AD-AS model, ination inertia is interpreted as persistent upward shifts of the AD and AS curves.
Increases in prices raise the expected price level, and shift the SRAS curve upwards. This continues until some
event changes ination, and thereby changes expected ination. On the other hand, the continued rise in the
aggregate demand is most often due to persistent growth in the money supply. If the central bank stops money
growth, the aggregate demand stabilizes, and the upward shift of the aggregate supply causes a recession. The
recession leads to high unemployment, which lowers ination and expected ination, dampening ination inertia.

3.3 Two Causes of Rising and Falling Ination

The second and third terms of the Phillips curve equation ((9) or (11)) indicate the two factors that may change
the ination rate.
The second term, (u un ), denotes the eect on ination of cyclical unemployment, or the deviation of
unemployment from its natural rate. Low unemployment pulls the the ination rate up. This is called demand-pull
ination, since high demand is responsible for this type of ination.
The third term, , shows the eect of supply shocks. An adverse supply shock, such as the oil shocks in the
1970s, implies a positive value of , and raises the ination rate. This is called cost-push ination. In the case
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of cost-push ination, the unemployment rate and the ination rate may rise simultaneously. Such case is called
stagation, since stagnation and ination occurs at the same time.

4 Ination and Unemployment

4.1 Short-run Tradeo Between Ination and Unemployment
Let us examine the policy options that the Phillips curve provides the policymakers. Expected ination and supply
shocks are dicult to control, but by aecting the aggregate demand by scal and monetary policy, it is possible
to change output, unemployment and ination in the short run.
Figure 3 plots the short-run Phillips curve, and shows the short run tradeo between ination and unemployment.
Note that a rise in the expected ination or an adverse supply shock shifts up the Phillips curve, and makes the
tradeo faced by the policymakers less favorable.
Importantly, people adjust their ination expectation over time, so such tradeo exists only in the short run. The
policymakers cannot keep the actual rate of ination above expected ination forever, and thus cannot permanently
keep unemployment below its natural rate. The classical dichotomy holds in the long run, and unemployment
returns to the natural rate.

E +

un

Figure 3: Short-run Tradeo Between Ination and Unemployment

4.2 Disination and the Sacrice Ratio

Consider an economy whose unemployment is at the natural rate, and the ination rate is 6 percent. If the central
bank adopts a policy to reduce the ination rate to 2 percent, what would happen to unemployment and output ?
The Phillips curve tells us that lowering ination requires a period of high ination and low output; but how large
are these changes, and how long do they last ?
A typical estimate, from the quantitative studies of the Phillips curve, of the sacrice ratio is about 5; this
means that to reduce the ination rate by 1 percentage point, 5 percent of one year's real GDP must be forgone.
We can also express the sacrice ratio in terms of the unemployment rate. Okun's law implies that a change of 1
percentage point in the unemployment rate corresponds to a change of 2 percentage points in GDP. Thus, to lower
the ination rate by 1 percentage point, it requires about 2.5 percentage points increase in cyclical unemployment.
With the sacrice ratio of 5, reducing the ination rate by 4 percentage points requires a sacrice of 20 percent
of a year's real GDP, corresponding to roughly 10 percentage points of cyclical unemployment. This disination
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could take various forms, for example, 10 percent lower output for 2 years, 2 percent lower output for 10 years, and
so on.

4.3 Rational Expectations and the Possibility of Painless Disination

Under the assumption of adaptive expectation, expected ination equals recently observed ination. An alternative
approach, which is more popular in recent years, is to assume that people have rational expectations. This approach
considers that when people forecast the future, they optimally use all the available information, including information
about government policies.
Therefore, when we evaluate the eects of policy changes under rational expectations, we must incorporate how
the policy changes aect the expectation. In this case, ination does not possess inherent momentum or inertia,
unlike under adaptive expectation. What raises expected ination and provides ination inertia is not ination
itself, but government policy such as budget decits and money creation.
So under this assumption, if the government credibly commits to reducing ination, rational people rapidly
decrease expected ination, hence ination can be lowered without a rise in unemployment and fall in output.
Thus, the costs of disination should be much smaller than what the estimate of the sacrice ratio indicates, and
the short run Phillips curve does not correctly depict the situation the government faces.
Textbook (p428-429) discusses an U.S. example of disination in the early 1980s. During this period, the Fed,
under Chairman Paul Volcker, pursued tight monetary policies to combat high ination. As a result, the ination
rate fell by 6.1 percentage points from 1982 to 1985. On the other hand, there were total of 10.0 percentage
points of cyclical unemployment over this period, which translates, from Okun's law, into 20 percent of a year's
real GDP. Thus, the sacrice ratio is 20/6.1=3.3, which is much smaller than the standard estimate of 5. A
possible interpretation of this result is that Chairman Volcker's tough stand towards ination lowered expectations
of ination directly, as is consistent with rational expectations view. The fall in expected ination, however, was
not large enough to eliminate the costs of disination.

4.4 Hysteresis and the Challenge to the Natural-Rate Hypothesis

The discussion in this lecture note, and more generally the Keynesian view on economic uctuation we have studied,
is based on an assumption called the natural-rate hypothesis. This hypothesis asserts that, while uctuations in
aggregate demand aects output, employment and unemployment in the short run, in the long run, these variables
revert to the levels described by the classical model.
However, some economists have challenged the natural rate hypothesis by arguing that the aggregate demand
aects output and employment even in the long run. Hysteresis is the term used to describe the persistent eects of
history on the natural rate. For example, workers who lost their jobs during recession may lose their skills during
unemployment, or may experience changes in their attitudes towards work and may have less incentives to search
for jobs. In such cases, recessions have permanent negative eect on the job search process, and increase frictional
unemployment. Moreover, unemployment makes part of insiders of the wage determination process to become
outsiders. If the diminished insider group values high real wages rather than high employment, the real wage rises
and permanently exceeds the equilibrium level, which increases structural unemployment.
In Europe, increases in unemployment occurred in the early 1980s along with disination, but continued even
after ination stabilized. Some economists argue that this can be explained by hysteresis. There is still no consensus,
however, on the signicance of the hysteresis phenomenon.