16.4: Review and Practice

Summary

During the 1960s, it appeared that there was a stable trade-off between the rate of unemployment and the rate of inflation. The Phillips curve, which describes such a trade-off, suggests that lower rates of unemployment come with higher rates of inflation, and that lower rates of inflation come with higher rates of unemployment. But during subsequent decades, the actual values for unemployment and inflation have not always followed the Phillips curve script.

There has, however, been a relationship between unemployment and inflation over the four decades from 1961. Periods of rising inflation and falling unemployment have been followed by periods of rising unemployment and continued inflation; those periods have, in turn, been followed by periods in which both the inflation rate and the unemployment rate fall. These periods are defined as the Phillips phase, the stagflation phase, and the recovery phase of the inflation—unemployment cycle, respectively. Following the recession of 2001, the economy returned quickly to a Phillips phase.

The Phillips phase is a period in which aggregate demand increases, boosting output and the price level. Unemployment drops and inflation rises. An essential feature of the Phillips phase is that the price increases that occur are unexpected. Workers thus experience lower real wages than they anticipated. Firms with sticky prices find that their prices are low relative to other prices. As workers and firms adjust to the higher inflation of the Phillips phase, they demand higher wages and post higher prices, so the short-run aggregate supply curve shifts leftward. Inflation continues, but real GDP falls. This is the stagflation phase. Finally, aggregate demand begins to increase again, boosting both real GDP and the price level. The higher price level, however, is likely to represent a much smaller percentage increase than had occurred during the stagflation phase. This is the recovery phase: inflation and unemployment fall together.

There is nothing inherent in a market economy that would produce the inflation—unemployment cycle we have observed since 1961. The cycle can begin if expansionary policies are launched to correct a recessionary gap, producing the Phillips phase. If those policies push the economy into an inflationary gap, then the adjustment of short-run aggregate supply will produce the stagflation phase. And, in the economy’s first response to an expansionary policy launched to deal with the recession of the stagflation phase, the price level rises, but at a slower rate than before. The economy experiences falling inflation and falling unemployment at the same time: the recovery phase.

In the long run, the Phillips curve is vertical, and inflation is essentially a monetary phenomenon. Assuming stable velocity of money over the long run, the inflation rate roughly equals the money growth rate minus the rate of growth of real GDP. For a given money growth rate, inflation is thus reduced by faster economic growth.

Frictional unemployment is affected by information costs in the labor market. A reduction in those costs would reduce frictional unemployment. Hastening the retraining of workers would reduce structural unemployment. Reductions in frictional or structural unemployment would lower the natural rate of unemployment and thus raise potential output. Unemployment compensation is likely to increase frictional unemployment.

Some economists believe that cyclical unemployment may persist because firms have an incentive to maintain real wages above the equilibrium level. Whether this efficiency-wage argument holds is controversial.

Concept Problems

1. The Case in Point titled “Some Reflections on the 1970s” describes the changes in inflation and in unemployment in 1970 and 1971 as a watershed development for macroeconomic thought. Why was an increase in unemployment such a significant event?
2. As the economy slipped into recession in 1980 and 1981, the Fed was under enormous pressure to adopt an expansionary monetary policy. Suppose it had begun an expansionary policy early in 1981. What does the text’s analysis of the inflation—unemployment cycle suggest about how the macroeconomic history of the 1980s might have been changed?

3. Here are some news reports covering events of the past 35 years. In each case, identify the stage of the inflation—unemployment cycle, and suggest what change in aggregate demand or aggregate supply might have caused it.

   1. “President Nixon expressed satisfaction with last year’s economic performance. He said that with inflation and unemployment heading down, the nation ‘is on the right course.’”
   2. “The nation’s inflation rate rose to a record high last month, the government reported yesterday. The consumer price index jumped 0.3% in January. Coupled with the announcement earlier this month that unemployment had risen by 0.5 percentage points, the reports suggested that the first month of President Nixon’s second term had gotten off to a rocky start.”
   3. “President Carter expressed concern about reports of rising inflation but insisted the economy is on the right course. He pointed to recent reductions in unemployment as evidence that his economic policies are working.”
4. The text notes that changes in oil prices can affect the inflation—unemployment cycle. Should they be incorporated as part of the theory of the cycle?
5. The introduction to this chapter suggests that unemployment fell, and inflation generally fell, through most of the 1990s. What phase of the inflation—unemployment cycle does this represent? Relative to U.S. experience since the 1960s, what was unusual about this?
6. Suppose that declining resource supplies reduce potential output in each period by 4%. What kind of monetary policy would be needed to maintain a zero rate of inflation at full employment?
7. The Humphrey–Hawkins Act of 1978 required that the federal government maintain an unemployment rate of 4% and hold the inflation rate to less than 3%. What does the inflation–unemployment relationship tell you about achieving such goals?
8. The American Economic Association publishes a newsletter (which is available on the AEA’s Internet site at http://www.aeaweb.org/joe/) called Job Openings for Economists (JOE). Virtually all academic and many nonacademic positions for which applicants are being sought for economics positions are listed in the newsletter, which is quite inexpensive. How do you think that the publication of this journal affects the unemployment rate among economists? What type of unemployment does it affect?
9. Many economists think that we are in the very early stages of putting computer technology to work and that full incorporation of computers will cause a massive restructuring of virtually every institution of modern life. If they are right, what are the implications for unemployment? What kind of unemployment would be affected?
10. The natural unemployment rate in the United States has varied over the last 50 years. According to the Congressional Budget Office, the natural rate was 5.5% in 1960, rose to about 6.5% in the 1970s, and had declined to about 4.8% by 2000. What do you think might have caused this variation?
11. Suppose the Fed begins carrying out an expansionary monetary policy in order to close a recessionary gap. Relate what happens during the next two phases of the inflation—unemployment cycle to the maxim “You can fool some of the people some of the time, but you can’t fool all of the people all of the time.”

Numerical Problems

1. Here are annual data for the inflation and unemployment rates for the United States for the 1948–1961 period.

   Year	Unemployment rate (%)	Inflation rate (%)
   1948	3.8	3.0
   1949	5.9	−2.1
   1950	5.3	5.9
   1951	3.3	6.0
   1952	3.0	0.8
   1953	2.9	0.7
   1954	5.5	−0.7
   1955	4.4	0.4
   1956	4.1	3.0
   1957	4.3	2.9
   1958	6.8	1.8
   1959	5.5	1.7
   1960	5.5	1.4
   1961	6.7	0.7

   1. Plot these observations and connect the points as in Figure 31.5.
   2. How does this period compare to the decades that followed?
   3. What do you think accounts for the difference?

2. Here are hypothetical inflation and unemployment data for Econoland.

   Time period	Inflation rate (%)	Unemployment rate (%)
   1	0	6
   2	3	4
   3	7	3
   4	8	5
   5	7	7
   6	3	6

   1. Plot these points.
   2. Identify which points correspond to a Phillips phase, which correspond to a stagflation phase, and which correspond to a recovery phase.
3. Relate the observations in Numerical Problem 2 to what must have been happening in the aggregate demand–aggregate supply model.
4. Suppose the full-employment level of real GDP is increasing at a rate of 3% per period and the money supply is growing at a 4% rate. What will happen to the long-run inflation rate, assuming constant velocity?