Inflation & Unemployment
The Phillips Curve
The Phillips curve describes the relationship between inflation and unemployment. In its modern form:
- π: actual inflation
- π****e: expected inflation
- u: actual unemployment rate
- u****n: natural rate of unemployment (NAIRU)
- β: sensitivity of inflation to the unemployment gap
- v: supply shock term
When actual unemployment is below the natural rate (u < u^n), inflation rises; when above, inflation falls.
Short-Run vs. Long-Run
In the short run, the Phillips curve slopes downward: lower unemployment comes with higher inflation. In the long run, the Phillips curve is vertical at u^n — the natural-rate hypothesis — because expectations adjust. Any attempt to keep unemployment below the natural rate leads to ever-accelerating inflation.
This insight won Edmund Phelps and Milton Friedman the Nobel Prize: there is no permanent trade-off between inflation and unemployment.
NAIRU
The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the unemployment rate consistent with stable inflation. It is not fixed — it changes with demographics, labor market institutions, and technology. Estimates of the US NAIRU have ranged from roughly 6.5% in the 1980s to around 4% in the late 2010s, though uncertainty around any estimate is large.
Adaptive vs. Rational Expectations
- Adaptive expectations: people form expectations based on past inflation. After a monetary expansion, inflation expectations rise gradually, so the short-run trade-off persists for a while before the Phillips curve shifts. This was the dominant view in the 1960s–1970s.
- Rational expectations (Lucas, Sargent): people use all available information, including knowledge of the policy regime, to form expectations. If the central bank credibly commits to low inflation, expectations adjust immediately and the disinflation can be nearly costless.
Lucas Critique
The Lucas critique argues that traditional macroeconometric models — which estimated Phillips curve relationships from historical data — cannot be used to evaluate alternative policies, because the parameters of the model (including expectations formation) change when the policy regime changes. A policy that appears optimal under historical relationships may fail once private agents adjust their behavior.
Volcker Disinflation (1979–1982)
When Paul Volcker became Fed chair in 1979, US inflation was above 10%. He raised the federal funds rate sharply, pushing it above 20% in 1981. The result was a deep recession (unemployment peaked at 10.8%) but inflation fell to about 3%.
The sacrifice ratio measures the cumulative output lost per percentage point of inflation reduction. Estimates for the Volcker disinflation range from 2 to 3 percentage points of GDP per point of inflation — a costly disinflation, but one that established the Fed’s anti-inflation credibility.
Hysteresis
Hysteresis is the hypothesis that cyclical unemployment can become structural. Prolonged unemployment erodes workers’ skills, reduces their attachment to the labor force, and stigmatizes them in the eyes of employers. When the economy recovers, the natural rate of unemployment may be permanently higher. This theory gained traction after the persistently high European unemployment of the 1980s and is invoked to explain post-2008 labor market scarring.
Six Debates over Macroeconomic Policy
1. Should policymakers try to stabilize the economy?
Yes: active stabilization reduces the severity of recessions and prevents needless suffering. No: time lags mean stabilization policy may arrive too late, and activist policy can itself be a source of instability.
2. Spending hikes vs. tax cuts in recessions?
Spending: government spending directly injects demand, especially if targeted at infrastructure with high multipliers. Tax cuts: tax cuts put money in private hands faster and avoid the inefficiency of government spending choices. Empirical evidence suggests the multiplier on spending exceeds the multiplier on tax cuts at the zero lower bound.
3. Rules vs. discretion in monetary policy?
Rules: a rule (e.g., the Taylor rule) anchors expectations, prevents time inconsistency, and provides predictability. Discretion: rules are too rigid; a discretionary central bank can respond to unforeseen circumstances (e.g., financial crises).
4. Should the central bank aim for zero inflation?
Zero inflation: eliminates the costs of inflation (menu costs, shoe-leather, bracket creep) and anchors expectations. Low but positive: zero risks deflation traps (Japan’s lost decade), and a positive target provides a buffer against the zero lower bound. Most central banks target around 2%.
5. Should the government balance its budget?
Balance: persistent deficits crowd out investment, impose intergenerational burdens, and risk fiscal crisis. Deficits in recessions: automatic stabilizers and counter-cyclical fiscal policy require deficits during downturns; the budget should balance over the cycle, not every year.
6. Should tax laws encourage saving?
Yes: saving funds investment, which drives long-run growth. Tax incentives (IRAs, 401(k)s) shift the consumption-saving trade-off. No: tax preferences for saving primarily benefit the wealthy; many households are already constrained in their ability to save, and the elasticity of saving with respect to tax incentives is modest.