# Trade-off between inflation and unemployment

### From Baripedia

In a long-term perspective, the level of economic activity does not depend on prices → classic dichotomy (differentiation between real and nominal variables and currency neutrality) → no trade-off between inflation and unemployment.

In the short term, prices and real output are linked (cf. AD-AO model) → possibility of trade-off between inflation and unemployment.

When there is a trade-off between the price level and the unemployment rate, expectations of future price developments and of the transition to the long term play a crucial role in economic dynamics.

As will be seen in this context, credible central banks can help to reduce the costs associated with high levels of unemployment.

# The short- and long-term Phillips curve and the role of expectations

## Trade-off between unemployment and inflation

In the long run:

• The natural unemployment rate depends on several characteristics

structural" labour market "structures": minimum wage legislation, the power of trade unions, efficiency wages, job search efficiency...

• The inflation rate depends on the growth rate of money which is controlled by the central bank (purely monetary phenomenon).

=> No trade-off between inflation and unemployment

In the short term (AD-AO model) :

• By implementing policies to expand aggregate demand, economic policy authorities can reduce unemployment but at the cost of higher inflation.
• By implementing restrictive policies, economic policy-makers can reduce inflation but at the price of higher unemployment.

=> Trade-off between inflation and unemployment

## Phillips curve

The Phillips curve represents the short-term relationship between inflation and unemployment.

## Derivation of the Phillips curve

A positive demand shock causes, in the short term, an increase in prices and output (graph a).

More output means less unemployment (reminder: Okun's Law, ch. 5). There is therefore an inverse relationship between inflation and unemployment = Phillips curve (graph b) → arbitrage.

## Long-term Phillips curve

In the 1960s Friedman and Phelps concluded that inflation and unemployment are not correlated in the long run.

The long-run Phillips curve is vertical to the natural rate of unemployment.

## The role of anticipations

Link between the short- and long-term Phillips curve: the role of expectations

The expected rate of inflation indicates the expectations of economic agents about future price developments.

From the operation of the aggregate supply function (ch. 12), we know that when the observed price is higher than the expected price, output is higher than the level of full employment, and vice versa → movement along the short-term OA curve.

Similarly, an unemployment rate lower than the natural unemployment rate (= the unemployment rate corresponding to the natural level of output) will be observed if the observed inflation rate is higher than the expected inflation rate → equation of the short-run Phillips curve :

${\displaystyle u=u_{N}-a(\pi -\pi ^{e})}$

where ${\displaystyle u_{N}}$ indicates the natural unemployment rate, ${\displaystyle \pi }$ the observed inflation rate, πe inflation expectations and parameter a is the slope of the short-term Phillips curve (NB: ${\displaystyle u=u_{N}}$ when ${\displaystyle \pi =\pi ^{e}}$).

In the long run, expected inflation adjusts to observed inflation: when ${\displaystyle Y>Y_{PE}}$ and ${\displaystyle P>P^{e}}$, agents expect the general price level to rise → shift the short-term OA curve to the left.

Similarly, a rise in the expected inflation rate causes the Phillips curve to shift to the right (see next chart).

Any change in inflation expectations causes the short-term Phillips curve to shift to the right. In particular, higher (low) expected inflation causes the Phillips curve to move to the right (left), resulting in a higher (low) inflation rate corresponding to ${\displaystyle u_{N}}$.

As a result, the central bank can only create unanticipated inflation (and thus lower the unemployment rate) in the short term.

## From short to long term

This relationship between accelerated inflation and the natural rate of unemployment is known as the natural rate hypothesis.

At the point ${\displaystyle B}$ there has not yet been any adjustment in inflation expectations (${\displaystyle \pi >\pi ^{e}}$).

At ${\displaystyle C}$ economic agents have adjusted their inflation expectations and ${\displaystyle \pi =\pi ^{e}}$.

Once in ${\displaystyle C}$, the only way to bring about a further fall in the unemployment rate is to accept even higher inflation by moving along the new Phillips curve (the one with high ${\displaystyle \pi ^{e}}$), which will cause the Phillips curve to move upwards again → acceleration of inflation.

## The NAIRU

The unemployment rate for which inflation does not vary over time is called the non-accelerating inflation rate of unemployment (NAIRU).

Keeping the unemployment rate below the NAIRU leads to accelerated inflation and is ultimately not possible for a long time.

The NAIRU gives us another way of defining the natural rate of unemployment defined in Chapter 5, which is the rate that the economy "needs" to avoid accelerated inflation.

## Offer shocks

Another reason that may explain the upward shifts in the short-term Phillips curve is the impact of supply shocks (e.g. ↑ of the oil price in the 1970s).

Large negative changes in the aggregate supply-side relationship can worsen the short-term trade-off between inflation and unemployment and make it more difficult for economic policy authorities to make a choice.

## The Phillips curve in the data

Historical evidence supports the natural rate hypothesis and shows that the short-term Phillips curve can shift as a result of changes in expectations.

Throughout the 1950s and 1960s the US experience clearly shows the existence of a short-term trade-off between unemployment and inflation (see chart on the next page). From the early 1970s onwards, this relationship seems to disappear from the data. During the 70s and 80s the US economy experienced a long period of above-average unemployment and high inflation rates = stagflation. In the 1990s the opposite situation occurred: relatively low inflation and unemployment.

One possible explanation is the shocks (oil prices and labour productivity) that caused the entire short-term Phillips curve to shift upwards in the 1970s (oil price shocks and stagflation) and downwards in the 1990s (technological progress and rising labour productivity).

## Note on inflation: main sources

In chapter 8 we explained inflation as a purely monetary phenomenon: the supply of money determines the price level and any excessive creation of money (not in relation to the rate of growth of output) causes inflation. NB: It should be noted that excessive money creation can sometimes be linked to the exchange rate regime (under a fixed exchange rate regime, continuous BC intervention).

With the development of the short-term model, we are now able to understand other sources of inflation:

• Cost inflation (autonomous increase in production costs, such as wages, return on capital, raw material prices... → the short term AO moves to the left and P↑);
• Demand inflation (excess demand for G&S offered in the economy → the DA moves to the right and the P↑);
• Imported inflation (rising prices of imported goods).

# Central bank credibility

## The role of central banks

The primary objective of the monetary policy authority is to keep inflation and its costs under control.

When the central bank tries to reduce inflation by conducting a restrictive monetary policy, this leads to lower output and, therefore, higher unemployment.

A disinflation process can at times be very costly in terms of unemployment over a prolonged period (moving along the short-term Phillips curve → Y low and u high).

It is therefore essential that the decline in the rate of inflation is pursued in a credible manner: the more credible the restrictive policy, the more quickly operators will adjust their expectations of the future development of the general price level and incorporate disinflation into their forecasts (movement along a lower Phillips curve → see graph).

This justifies, once again, the need for central banks to be independent of political power.

On the role of CBs see The Economist 17.09.2011 and 28.07.2012

## Disinflation

The more credible the restrictive policy is, the faster the economy moves from ${\displaystyle B}$ to ${\displaystyle C}$ thereby reducing the costs associated with high unemployment (point ${\displaystyle B}$).

## Inflation Targeting and the Liquidity Trap

The central bank has several instruments at its disposal to achieve its inflation targets. The money supply and the exchange rate can be seen as intermediate targets of monetary policy, with the price level as the ultimate target.

Since the central bank does not have perfect control over either the money supply or the exchange rate, it is thought that it should directly pursue a certain target rate of inflation and use the interest rate to expect that target.

There are situations in which monetary policy becomes completely ineffective and cannot have any impact on the economy. This happens when the nominal interest rate is already equal to zero. With a very low interest rate everyone wants to conserve cash and any further increase in the money supply is completely absorbed by individuals without the interest rate falling and spending increasing (perfectly elastic demand for money). This situation is known as a liquidity trap (see section 13).

# Summary

The Phillips curve describes the inverse relationship between inflation and unemployment.

By pursuing an expansive (restrictive) policy, economic policy authorities can choose along the short-term Phillips curve a combination of higher (low) inflation and lower (high) unemployment.

The trade-off between inflation and unemployment only occurs in the short term. The long-term Phillips curve is a vertical line corresponding to the natural unemployment rate.

The short-term Phillips curve may shift either because of changes in expectations of future price developments or because of aggregate supply shocks.

A negative supply shock deteriorates the trade-off between unemployment and inflation that the government faces.

A restrictive monetary policy that aims to reduce the inflation rate temporarily increases the unemployment rate.

The cost of disinflation depends on how quickly traders adjust their inflation expectations.

The more credible the central bank is, the faster traders will adjust their expectations and the lower the costs to the community in terms of high unemployment.

By being the controller of the imperfect money supply, the central bank should set these targets in terms of the inflation rate and use the interest rate to wait for its targets.

When the nominal interest rate is equal to zero, traditional monetary policy has no impact on the economic system because individuals keep the money and do not increase their spending.

# Annexes

• The Economist, Anatomy of a hump, 08.03.2007
• The Economist, Prices or jobs?, 17.09.2011
• The Economist, The Chicago question, 28.07.2012