CHAPTER SUMMARY
1. Following the famous 1958 article by A. W. Phillips, empirical studies often showed that inflation is high when unemployment is low and low when unemployment is high. This negative empirical relationship between inflation and unemployment is called the Phillips curve.
Inflation and unemployment in the United States conformed to the Phillips curve during the 1960s but not during the 1970s and 1980s.2. Economic theory suggests that, in general, the negative relationship between inflation and unemployment should not be stable. Instead, in an economy in which there are unanticipated changes in the growth rate of aggregate demand, there should be a negative relationship between unanticipated inflation and cyclical unemployment. In particular, when actual and expected inflation are equal (so that unanticipated inflation is zero), the actual unemployment rate will equal the natural unemployment rate (so that cyclical unemployment is zero). This negative relationship between unanticipated inflation and cyclical unemployment is called the expectations-augmented Phillips curve.
3. According to the theory of the expectations-augmented Phillips curve, a stable negative relationship between inflation and unemployment (a Phillips curve) will be observed only if expected inflation and the natural unemployment rate are constant. An increase in expected inflation or an increase in the natural unemployment rate shifts the short-run Phillips curve up and to the right. Adverse supply shocks typically increase both expected inflation and the natural unemployment rate and thus shift the short-run Phillips curve up and to the right. Major supply shocks during the 1970s, a rising natural unemployment rate, and highly variable expected inflation rates explain why the Phillips curve shifted erratically in the United States after about 1970.
4.
According to the expectations-augmented Phillips curve, macroeconomic policy can reduce unemployment below the natural rate only by surprising the public with higher-than-expected inflation. Classical economists argue that, because of rational expectations and rapid price adjustment, policy cannot be used systematically to create inflation higher than expected; thus policymakers cannot usefully exploit the Phillips curve relationship by trading higher inflation for lower unemployment. Keynesians believe that, because not all prices adjust rapidly to reflect new information, policymakers are able to create surprise inflation temporarily and thus trade off inflation and unemployment in the short run.5. Classicals and Keynesians agree that, in the long run, expected and actual inflation rates are equal. Thus in the long run the actual unemployment rate equals the natural rate, regardless of the inflation rate. Reflecting the fact that there is no long-run trade-off between inflation and unemployment, the long-run Phillips curve is vertical at the natural unemployment rate.
6. The costs of unemployment include output lost when fewer people are working and the personal or psychological costs for workers who are unemployed, their families, and close associates.
7. In the long run the unemployment rate is determined by the natural unemployment rate. According to some estimates, the natural unemployment rate in the United States rose during the 1960s and 1970s but has since declined. Demographic changes in the labor force help to explain many of these changes. However, although policymakers would like to have a precise estimate of the natural rate of unemployment, economists have been unable to measure it very precisely.
8. The costs of inflation depend on whether the inflation was anticipated or unanticipated. The costs of anticipated inflation, which (except in extreme inflations) are relatively minor, include shoe leather costs (resources used by individuals and firms to reduce their holdings of currency) and menu costs (costs of changing posted prices during an inflation).
Unanticipated inflation causes unpredictable transfers of wealth among individuals and firms. The risk of unpredictable gains and losses, and the resources that people expend in trying to reduce this risk, are costs of unanticipated inflation. Unanticipated inflation may also reduce the efficiency of the market system by making it more difficult for people to observe relative prices.9. Disinflation is a reduction in the rate of inflation. Attempts to disinflate by slowing money growth will cause cyclical unemployment to rise if actual inflation falls below expected inflation. To reduce the unemployment cost of disinflation, the public's expected inflation rate should be brought down along with the actual inflation rate. Strategies for reducing expected inflation include rapid and decisive reduction in the growth rate of the money supply (the cold-turkey approach), wage and price controls, and taking measures to improve the credibility of government policy announcements.
10. The disinflation that occurred in the United States in the 1980s and 1990s was costly at first because expected inflation did not decline immediately. But as time passed and the Federal Reserve gained credibility, inflation expectations declined, along with inflation.
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