Chapter 12Chapter OutlineUnemployment and Inflation: Is There a Trade-off?Figure 12.1 The Phillips curve and the U.S. economy during the 1960sUnemployment and Inflation: Is There a Trade-off?Figure 12.2 Inflation and unemployment in the United States, 1970-2005Slide 7Slide 8Figure 12.3 Ongoing inflation in the extended classical modelSlide 10Figure 12.4 Unanticipated inflation in the extended classical modelSlide 12Slide 13Figure 12.5 The shifting Phillips curve: an increase in expected inflationSlide 15Slide 16Figure 12.6 The shifting Phillips curve: an increase in the natural unemployment rateSlide 18Slide 19Slide 20Slide 21Slide 22Figure 12.7 The expectations-augmented Phillips curve in the United States, 1970-2005Slide 24Slide 25Slide 26Slide 27Slide 28Slide 29Figure 12.8 The long-run Phillips curveSlide 31The Problem of UnemploymentSlide 33Slide 34Slide 35Figure 12.9 Actual and natural unemployment rates in the United States, 1960-2005Slide 37Slide 38Slide 39Slide 40Slide 41The Problem of InflationSlide 43Slide 44Slide 45Slide 46Slide 47Slide 48Slide 49Slide 50Slide 51Slide 52Slide 53Slide 54Slide 55Slide 56Slide 57Slide 58Slide 59Slide 60Slide 61Slide 62Figure 12.10 Expected inflation rate, 1971 to 2006Slide 64© 2008 Pearson Addison-Wesley. All rights reservedChapter 12Unemployment and Inflation© 2008 Pearson Addison-Wesley. All rights reserved12-2Chapter Outline•Unemployment and Inflation: Is There a Trade-Off?•The Problem of Unemployment•The Problem of Inflation© 2008 Pearson Addison-Wesley. All rights reserved12-3Unemployment and Inflation: Is There a Trade-off? •Many people think there is a trade-off between inflation and unemployment–The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain–Since then economists have looked at the relationship between unemployment and inflation–In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables–The United States appears to be on one Phillips curve in the 1960s (Fig. 12.1)© 2008 Pearson Addison-Wesley. All rights reserved12-4Figure 12.1 The Phillips curve and the U.S. economy during the 1960s© 2008 Pearson Addison-Wesley. All rights reserved12-5Unemployment and Inflation: Is There a Trade-off?•Many people think there is a trade-off between inflation and unemployment–This suggested that policymakers could choose the combination of unemployment and inflation they most desired–But the relationship fell apart in the following three decades (Fig. 12.2)–The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve© 2008 Pearson Addison-Wesley. All rights reserved12-6Figure 12.2 Inflation and unemployment in the United States, 1970-2005© 2008 Pearson Addison-Wesley. All rights reserved12-7Unemployment and Inflation: Is There a Trade-off?•The expectations-augmented Phillips curve–Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation)•This theory was made before the Phillips curve began breaking down in the 1970s•It suggests that the relationship between inflation and the unemployment rate isn’t stable© 2008 Pearson Addison-Wesley. All rights reserved12-8Unemployment and Inflation: Is There a Trade-off?•The expectations-augmented Phillips curve–How does this work in the extended classical model?•First case: anticipated increase in money supply (Fig. 12.3) –AD shifts up and SRAS shifts up, with no misperceptions–Result: P rises, Y unchanged–Inflation rises with no change in unemployment© 2008 Pearson Addison-Wesley. All rights reserved12-9Figure 12.3 Ongoing inflation in the extended classical model© 2008 Pearson Addison-Wesley. All rights reserved12-10Unemployment and Inflation: Is There a Trade-off?•The expectations-augmented Phillips curve–How does this work in the extended classical model?•Second case: unanticipated increase in money supply (Fig. 12.4) –AD expected to shift up to AD2,old (money supply expected to rise 10%), but unexpectedly money supply rises 15%, so AD shifts further up to AD2,new–SRAS shifts up based on expected 10% rise in money supply–Result: P rises and Y rises as misperceptions occur–So higher inflation occurs with lower unemployment–Long run: P rises further, Y declines to full-employment level© 2008 Pearson Addison-Wesley. All rights reserved12-11Figure 12.4 Unanticipated inflation in the extended classical model© 2008 Pearson Addison-Wesley. All rights reserved12-12Unemployment and Inflation: Is There a Trade-off?•The expectations-augmented Phillips curve (12.1)•When   e, u  •When   e, u  •When   e, u  u( )eh u up p= - -uu© 2008 Pearson Addison-Wesley. All rights reserved12-13Unemployment and Inflation: Is There a Trade-off?•The shifting Phillips curve–The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment–Changes in the expected rate of inflation (Fig. 12.5)© 2008 Pearson Addison-Wesley. All rights reserved12-14Figure 12.5 The shifting Phillips curve: an increase in expected inflation© 2008 Pearson Addison-Wesley. All rights reserved12-15Unemployment and Inflation: Is There a Trade-off?•The shifting Phillips curve–Changes in the expected rate of inflation (Fig. 12.5)•For a given expected rate of inflation, the Phillips curve shows the trade-off between cyclical unemployment and actual inflation•The Phillips curve is drawn such that   e when u  •Higher expected inflation implies a higher Phillips curveu© 2008 Pearson Addison-Wesley. All rights reserved12-16Unemployment and Inflation: Is There a Trade-off?•The shifting Phillips curve–Changes in the natural rate of unemployment (Fig. 12.6)•For a given natural rate of unemployment, the Phillips curve shows the trade-off between unemployment and unanticipated inflation•A higher natural rate of unemployment shifts the Phillips curve to the right© 2008 Pearson Addison-Wesley. All rights reserved12-17Figure 12.6 The shifting Phillips curve: an increase in the natural unemployment rate© 2008 Pearson Addison-Wesley. All rights reserved12-18Unemployment and Inflation: Is There