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15.1: Relating Inflation and Unemployment

  • Page ID
    17181
  • Learning Objectives

    1. Draw a short-run Phillips curve and describe the relationship between inflation and unemployment that it expresses.
    2. Describe the other relationships or phases that have been observed between inflation and unemployment.

    It has often been the case that progress against inflation comes at the expense of greater unemployment, and that reduced unemployment comes at the expense of greater inflation. This section looks at the record and traces the emergence of the view that a simple trade-off between these macroeconomic “bad guys” exists.

    Clearly, it is desirable to reduce unemployment and inflation. Unemployment represents a lost opportunity for workers to engage in productive effort—and to earn income. Inflation erodes the value of money people hold, and more importantly, the threat of inflation adds to uncertainty and makes people less willing to save and firms less willing to invest. If there were a trade-off between the two, we could reduce the rate of inflation or the rate of unemployment, but not both. The fact that the United States did make progress against unemployment and inflation through most of the 1990s and early 2000s represented a macroeconomic triumph, one that appeared impossible just a few years earlier. The next section examines the argument that once dominated macroeconomic thought—that a simple trade-off between inflation and unemployment did, indeed, exist. The argument continues to appear in discussions of macroeconomic policy today; it will be useful to examine it.

    The Phillips Curve in the Short Run

    In 1958, New Zealand–born economist Almarin Phillips reported that his analysis of a century of British wage and unemployment data suggested that an inverse relationship existed between rates of increase in wages and British unemployment (Phillips, 1958). Economists were quick to incorporate this idea into their thinking, extending the relationship to the rate of price-level changes—inflation—and unemployment. The notion that there is a trade-off between the two is expressed by a short-run Phillips curve, a curve that suggests a negative relationship between inflation and unemployment. Figure 16.1 “The Short-Run Phillips Curve” shows a short-run Phillips curve.

    Figure 16.1 The Short-Run Phillips Curve

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    The relationship between inflation and unemployment suggested by the work of Almarin Phillips is shown by a short-run Phillips curve.

    The short-run Phillips curve seemed to make good theoretical sense. The dominant school of economic thought in the 1960s suggested that the economy was likely to experience either a recessionary or an inflationary gap. An economy with a recessionary gap would have high unemployment and little or no inflation. An economy with an inflationary gap would have very little unemployment and a higher rate of inflation. The Phillips curve suggested a smooth transition between the two. As expansionary policies were undertaken to move the economy out of a recessionary gap, unemployment would fall and inflation would rise. Policies to correct an inflationary gap would bring down the inflation rate, but at a cost of higher unemployment.

    The experience of the 1960s suggested that precisely the kind of trade-off the Phillips curve implied did, in fact, exist in the United States. Figure 16.2 “The Short-Run Phillips Curve in the 1960s” shows annual rates of inflation (computed using the implicit price deflator) plotted against annual rates of unemployment from 1961 to 1969. The points appear to follow a path quite similar to a Phillips curve relationship. The civilian unemployment rate fell from 6.7% in 1961 to 3.5% in 1969. The inflation rate rose from 1.1% in 1961 to 4.8% in 1969. While inflation dipped slightly in 1963, it appeared that, for the decade as a whole, a reduction in unemployment had been “traded” for an increase in inflation.

    Figure 16.2 The Short-Run Phillips Curve in the 1960s

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    Values of U.S. inflation and unemployment rates during the 1960s generally conformed to the trade-off implied by the short-run Phillips curve. The points for each year lie close to a curve with the shape that Phillips’s analysis predicted.

    Source: Economic Report of the President, 2011, Tables B-3 and B-42.

    In the mid-1960s, the economy moved into an inflationary gap as unemployment fell below its natural level. The economy had already reached its full employment level of output when the 1964 tax cut was passed. The Fed undertook a more expansionary monetary policy at the same time. The combined effect of the two policies increased aggregate demand and pushed the economy beyond full employment and into an inflationary gap. Aggregate demand continued to rise as U.S. spending for the war in Vietnam expanded and as President Lyndon Johnson launched an ambitious program aimed at putting an end to poverty in the United States.

    By the end of the decade, unemployment at 3.5% was substantially below its natural level, estimated by the Congressional Budget Office to be 5.6% that year. When Richard Nixon became president in 1969, it was widely believed that, with an economy operating with an inflationary gap, it was time to move back down the Phillips curve, trading a reduction in inflation for an increase in unemployment. President Nixon moved to do precisely that, serving up a contractionary fiscal policy by ordering cuts in federal government purchases. The Fed pursued a contractionary monetary policy aimed at bringing inflation down.

    The Short-Run Phillips Curve Goes Awry

    The effort to nudge the economy back down the Phillips curve to an unemployment rate closer to the natural level and a lower rate of inflation met with an unhappy surprise in 1970. Unemployment increased as expected. But inflation rose! The inflation rate rose to 5.3% from its 1969 rate of 4.8%.

    The tidy relationship between inflation and unemployment that had been suggested by the experience of the 1960s fell apart in the 1970s. Unemployment rose substantially, but inflation remained the same in 1971. In 1972, both rates fell. The economy seemed to fall back into the pattern described by the Phillips curve in 1973, as inflation rose while unemployment fell. But the next two years saw increases in both rates. The negatively sloped Phillips curve relationship between inflation and unemployment that had seemed to hold true in the 1960s no longer prevailed.

    Indeed, a look at annual rates of inflation and unemployment since 1961 suggests that the 1960s were quite atypical. Figure 16.3 “Inflation and Unemployment, 1961–2011” shows the two variables over the period from 1961 through 2011. It is hard to see a negatively sloped Phillips curve lurking within that seemingly random scatter of points.

    Figure 16.3 Inflation and Unemployment, 1961–2011

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    Annual observations of inflation and unemployment in the United States from 1961 to 2011 do not seem consistent with a Phillips curve.

    Sources: Economic Report of the President, 2011, Table B-42; Bureau of Economic Analysis, Implicit Price Deflators for Gross Domestic Product, NIPA Table 1.1.9. Unemployment rate for 2011 is annual average from Bureau of Labor Statistics home page.