Inflation, Unemployment, and Federal Reserve Policy: The Phillips Curve and Modern Central Banking

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Chapter 17: Inflation, Unemployment, and Federal Reserve Policy

17.1 The Discovery of the Short-Run Trade-Off between Unemployment and Inflation

The Federal Reserve (Fed) faces two major short-run macroeconomic challenges: unemployment and inflation. These two variables are often inversely related in the short run, a relationship captured by the Phillips curve.

Phillips Curve: A graph showing the short-run relationship between the unemployment rate and the inflation rate. Discovered by A.W. Phillips, it suggests that higher inflation is associated with lower unemployment, and vice versa.
Policy Implication: In the short run, policymakers may face a trade-off between reducing unemployment and controlling inflation.

Example: If the Fed increases aggregate demand, unemployment may fall but inflation may rise.

Figure 17.1 The Phillips Curve

The Phillips curve is typically downward sloping, indicating the inverse relationship between inflation and unemployment in the short run.

Figure 17.2 Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve

In the AD-AS model, a small aggregate demand increase leads to low inflation and high unemployment.
A strong AD increase results in lower unemployment but higher inflation, reflecting the short-run Phillips curve.

Is the Phillips Curve a Policy Menu?

In the 1960s, some economists believed the Phillips curve was a structural relationship—stable over time and allowing policymakers to choose a preferred combination of inflation and unemployment.
This view was later challenged: allowing more inflation does not lead to permanently lower unemployment.

Figure 17.3 A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve

By the late 1960s, economists like Milton Friedman and Edmund Phelps argued that the long-run aggregate supply (AS) curve is vertical, implying the long-run Phillips curve is also vertical.
In the long run, unemployment returns to the natural rate of unemployment, determined by structural and frictional factors, not by inflation.

Key Terms:

Natural Rate of Unemployment: The unemployment rate when the economy is at potential GDP; includes only structural and frictional unemployment.
Cyclical Unemployment: Unemployment caused by economic downturns; zero at the natural rate.

The Role of Expectations of Future Inflation

The short-run trade-off between inflation and unemployment exists partly because workers and firms may misjudge future inflation.

If inflation is higher than expected, real wages fall, and unemployment drops as firms hire more.
If inflation is lower than expected, real wages rise, and unemployment increases as firms hire less.

Formula:

Table 17.1 The Effect of Unexpected Price Level Changes on the Real Wage

Nominal Wage	Expected Real Wage	Actual Real Wage with 1% Inflation	Actual Real Wage with 6% Inflation
$50.00	$40.45	$41.25	$39.31

If inflation is as expected, the real wage is as planned. If inflation is lower (higher) than expected, the real wage is higher (lower) than expected, affecting hiring decisions.

Table 17.2 The Basis for the Short-Run Phillips Curve

If ...	then ...	and ...
actual inflation is greater than expected inflation	the actual real wage is less than the expected real wage	the unemployment rate falls
actual inflation is less than expected inflation	the actual real wage is greater than the expected real wage	the unemployment rate rises

Why Might Workers Fail to Accurately Forecast Inflation?

Workers may not expect their wages to rise with inflation, so firms can increase wages by less than inflation without losing workers.

17.2 The Short-Run and Long-Run Phillips Curves

The relationship between the short-run and long-run Phillips curves is central to understanding inflation and unemployment dynamics.

In the short run, unexpected inflation can reduce unemployment below the natural rate.
In the long run, expectations adjust, and unemployment returns to the natural rate, regardless of inflation.

Figure 17.4 The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve

Unexpected inflation in the late 1960s led to lower unemployment, but as expectations adjusted, the economy returned to the natural rate of unemployment.

Figure 17.5 Expectations and the Short-Run Phillips Curve

As workers and firms adjust expectations, the short-run Phillips curve shifts upward, and the economy returns to the long-run Phillips curve.

Figure 17.6 A Short-Run Phillips Curve for Every Expected Inflation Rate

Each expected inflation rate generates a different short-run Phillips curve. When actual inflation matches expected inflation, unemployment is at its natural rate.

Figure 17.7 The Inflation Rate and the Natural Rate of Unemployment in the Long Run

To keep unemployment below the natural rate, inflation must continually accelerate.
The natural rate of unemployment is also called the nonaccelerating inflation rate of unemployment (NAIRU).

Does the Natural Rate of Unemployment Ever Change?

Demographic changes: Younger, less skilled workers have higher unemployment rates.
Labor market institutions: Changes in unemployment insurance, union prevalence, or firing laws can affect the natural rate.
Past high unemployment: Prolonged unemployment can erode skills or increase dependency on government support.

17.3 Monetary Policy and Expectations of the Inflation Rate

Expectations about inflation play a crucial role in determining the effectiveness of monetary policy and the duration of deviations from the long-run Phillips curve.

Low inflation: Expectations adjust slowly; workers and firms may ignore inflation.
Moderate but stable inflation: Expectations adjust quickly; inflation is incorporated into wage and price setting.
High and unstable inflation: Expectations adjust rapidly; rational expectations become important.
Rational expectations: Expectations formed using all available information about an economic variable.

Figure 17.8 Rational Expectations and the Phillips Curve

If workers and firms have adaptive expectations (expecting inflation to be the same as last period), expansionary policy can temporarily reduce unemployment.
If they have rational expectations, they anticipate policy changes, and the short-run Phillips curve becomes vertical—policy has no effect on unemployment.

Is the Short-Run Phillips Curve Really Vertical?

Some economists (Lucas and Sargent) argue that with rational expectations, the short-run Phillips curve is vertical.
Critics argue that expectations are not always rational and wages/prices do not adjust instantly, so a short-run trade-off can exist.

Real Business Cycle Models

Focus on real (not monetary) shocks, such as technology changes, as the main source of fluctuations in real GDP.
Assume rational expectations and quickly adjusting prices; part of new classical macroeconomics.

17.4 The Development of Federal Reserve Policy since the 1970s and the Operation of Foreign Central Banks

Federal Reserve policy has evolved in response to inflation, supply shocks, and changing economic theories.

In the late 1960s and early 1970s, Fed policy contributed to high inflation.
OPEC oil shocks in the 1970s caused supply shocks, raising inflation and unemployment (stagflation).

Figure 17.9 A Supply Shock Shifts the SRAS Curve and the Short-Run Phillips Curve

Supply shocks (e.g., oil price increases) shift the short-run aggregate supply (SRAS) curve left, raising inflation and unemployment simultaneously.

Additional info:

Modern central banks, including the Fed, Bank of England, Bank of Japan, Bank of Canada, and European Central Bank, have adopted varying degrees of independence and transparency to enhance policy effectiveness and credibility.