Output-Inflation Tradeoffs Around the World

Output-Inflation Tradeoff is a relationship between deviations of real GDP from full

employment and inflation from its expected level. It tells us the cost of reducing inflation below its
expected level in terms of the amount of real GDP forgone. This cost is measured by the slope at the
output-inflation tradeoff.

The output-inflation tradeoff is a loss of real GDP resulting from a given

percentage decrease in inflation. The steeper the output-inflation tradeoff
curve, the smaller is the cost of reducing inflation in terms of lost real GDP.
Countries with high and variable inflation rates have a steep tradeoff while
countries with low and steady inflation have a flat tradeoff.

The idea of an output-inflation tradeoff suggests a stable relationship between deviations of real
GDP from its capacity level and inflation rate. In fact, no such relationship exists. The evolution of
inflation and deviations of GDP from capacity follow an unfolding loop-like pattern wherein there is no
visible sign of tradeoff.

This sequence of
points is a result from
a combination of two
forces – changes in
inflation expectations
and movements
along an output-
inflation tradeoff.
The New Classical Theory of the Labor Market

“How do firms decide on the quantity of labor to hire, and how do households decide on the
quantity of labor to supply?”

A firm maximizes its profit by hiring the quantity of labor that makes the marginal product of
labor equal to the firm’s real wage rate (money wage rate divided by the price of its output). And a household
chooses the amount of labor to supply on the basis of real wage rate it receives, which is the basket of
goods and services it can buy with the money wage rate. This wage rate is the money wage rate divided
by the price level.

Notice that the relevant price for calculating the real wage rate is not the same on both sides of the
market:

DEMAND SIDE SUPPLY SIDE

Price at which the firm can sell its output Average price of all the goods and services
households buy.

This information difference is the basis of the new classical theory of the labor market.

1. The quantity of labor demanded depends on the actual real wage rate.

2. The quantity of labor supplied depends on the actual real wage rate.

3. The average money wage rate continually adjusts to achieve labor market equilibrium.

On the Demand Side

Each firm hires labor for the basis of the actual wage rate it pays. If we sum the labor demands
of all firms and take an average of the real wage rates faced by firms, we obtain the aggregate or
economywide demand for labor. The aggregate quantity of labor depends on the actual economy-
average real wage rate.

Each firm knows only the price of its own output, but in aggregate, firms behave as if they know
the actual price level. That is, the aggregate quantity of labor demanded depends on the actual price
level.

On the Supply Side

Households have to base their labor supply decisions in an expectation of the average price of
the goods and services they buy. That is, the quantity of labor supplied by households is determined by
their expectation of the real wage rate. The economywide aggregate supply of labor is the sum of the
supply of labor of all households. Since each household’s labor supply decision depends on the expected
real wage rate, so does the aggregate quantity of labor supplied.
 Thus, once households’ incomplete information on prices is taken into account, a crucial
difference exists between the aggregate demand and supply of labor: the quantity of labor
demanded depends on the actual wage rate, while the quantity of labor supplied depends on
the expected real wage rate.

The Labor Market Equilibrium

To study labor market equilibrium, let us see how the money wage is determined.

Money Wage Rate

The equilibrium shown is a real equilibrium, independent of the price level.

But the equilibrium depicted above is not dependent of the price level. Since money wage rate
is measured on the vertical axis, the labor demand and supply curves can be drawn only for a given price
level. So an increase in the price level shifts both the labor demand and the labor supply curve. The
money wage rate increases but the employment remains unchanged.
 Incomplete information and expectations

The above figure shows how the new classical labor market works. The demand for labor curve
depends on the actual price level and the supply of labor curve depends on the expected price level.
When actual price level and expected price level is equal, unemployment is at its natural rate.

Once we introduce incomplete information, equilibrium in the labor market depends on the
price level relative to the expected price level. If the expected price level actually comes about, the labor
market settles down at its natural rate of unemployment. If the price level is higher than expected, the
labor market settles down with unemployment below its natural rate. If the price level turns out to be
lower than expected, the labor market settles down with unemployment above its natural rate.

Lucas Aggregate Supply Curve

This curve shows the maximum real GDP supplied at each price level when the labor market is in
equilibrium at a given expected price level. The Lucas aggregate supply curve is a particular case of the
short-run aggregate supply curve. What’s constant along the Lucas aggregate supply curve is the
expected price level. The money wage is not fixed; it adjusts, given the expected price level to keep the
market in equilibrium.

At each different price level, there is

a different market equilibrium. The
employment levels associated with
these equilibrium positions
translate to different output levels,
using the short-run production
function part (b)
 The output levels associated
with different price levels
generate a short-run aggregate
supply curve (the Lucas
aggregate supply curve), ASL
(part c). On that supply curve, at
point E the economy is at full
employment, and at point F
there is unemployment.

For a given expected price level, as the actual price level increases, the money wage increases
and the labor market equilibrium occurs at higher and higher levels of unemployment. With higher
employment, there is a higher level of real GDP.