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Inflation Rate
7 1977
be generated when economic fluctuations come from
the supply side? 1968 1971
Figure 2 reminds us that output will decline (or at 1969 1976
least grow more slowly) and prices will rise when the 1982
economy is hit by an adverse supply shock. Now, in a 1966
4 1984
growing population with more people looking for jobs 1983
3 1954
each year, a stagnant economy that does not generate 1962
enough new jobs will suffer a rise in unemployment. 1967 1959 1958
Thus inflation and unemployment will rise together: 1961
If fluctuations in economic activity emanate from
the supply side, higher rates of inflation will be as- 0 1 2 3 4 5 6 7 8 9 10
sociated with higher rates of unemployment, and
Unemployment Rate in Percent
lower rates of inflation will be associated with lower
rates of unemployment.
F I GU R E 6
The major supply shocks of the 1970s stand out clearly in Figure 6. (Remember”these
A Phillips Curve for the
are real data, not textbook examples.) Food prices soared from 1972 to 1974, and again in United States?
1978. Energy prices skyrocketed in 1973“1974, and again in 1979“1980. Clearly, the infla-
tion and unemployment data generated by the U.S. economy in 1972“1974 and in
1978“1980 are consistent with our model of supply-side inflation. Most economists believe
that supply shocks, not demand shocks, dominated the decade from 1972 to 1982.

Explaining the Fabulous 1990s
Now let™s stand this analysis of supply shocks on its head. Suppose the economy experiences
F I GU R E 7
a favorable supply shock, rather than an adverse one, so that the aggregate supply curve shifts
The Effects of a
outward at an unusually rapid rate. Any number of factors”such as a drop in oil prices,
Favorable Supply Shock
bountiful harvests, or exceptionally rapid techno-
logical advance”can have this effect.
Nor mal growth
Whatever the cause, Figure 7 (which dupli- D1
of aggregate supply
cates Figure 14 of Chapter 10) depicts the conse- S1
quences. The aggregate demand curve shifts
outward as usual, but the aggregate supply curve
shifts out more than it would in a “normal” year. C
So the economy™s equilibrium winds up at point
Price Level

A Effect of favorable
B rather than at point C, meaning that economic B
supply shock
growth is faster (B is to the right of C) and infla-
tion is lower (B is below C). Thus, inflation falls
while rapid growth reduces unemployment.
Figure 7 more or less characterizes the experi-
ence of the U.S. economy from 1996 to 1998. Oil D1
prices plummeted, lowering costs to American S1 D0
businesses and households. Stunning advances
in technology made computer prices drop even
Real GDP
more rapidly than usual. And the rising value of

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Part 3
322 Fiscal and Monetary Policy

the U.S. dollar made imported goods cheaper to Americans.1 Thus, we benefited from a
series of favorable supply shocks, and the effects were as depicted in Figure 7. The U.S.
economy grew rapidly, and inflation and unemployment fell together.

We now have the answer to the question posed at the start of this chapter. We
do not need to add anything new or mysterious to explain the marvelous eco-
nomic performance of the second half of the 1990s. According to the basic
macroeconomic theory taught in this book, favorable supply shocks should
produce rapid economic growth with falling inflation”which is just what hap-
pened. The U.S. economy did so well, in part, because we were so fortunate.

So one view of what went wrong with the Phillips curve is that adverse supply shocks
dominated the 1970s and early 1980s. But there is another view, one that holds that policy
makers misinterpreted the Phillips curve and tried to pick combinations of inflation and
unemployment that were simply unsustainable.
Specifically, we have learned that the Phillips curve is a statistical relationship between
inflation and unemployment that we expect to emerge if business cycle fluctuations arise
mainly from changes in the growth of aggregate demand. But in the 1970s and 1980s, the curve
was widely misinterpreted as depicting a number of alternative equilibrium points from
which policy makers could choose.
To understand the flaw in this reasoning, let us quickly review an earlier lesson. We
know from Chapter 10 that the economy has a self-correcting mechanism that will cure both
inflations and recessions eventually, even if the government does nothing. This idea is im-
portant in this context because it tells us that many combinations of output and prices can-
not be maintained indefinitely. Some will self-destruct. Specifically, if the economy finds
itself far from the normal full-employment level of unemployment, forces will be set in
F I GU R E 8 motion that tend to erode the inflationary or recessionary gap.
The Elimination of a Figure 8 depicts the case of a recessionary gap where ag-
Recessionary Gap gregate supply curve S0S0 intersects aggregate demand
curve DD at point A. With equilibrium output well below
potential GDP, the economy has unused industrial capacity
GDP and unsold output, so inflation will be tame. At the same
time, the availability of unemployed workers eager for jobs
limits the rate at which labor can push up wage rates. But
since wages are the main component of business costs, when
S2 they decline (relative to what they would have been without
Price Level

a recession) so do costs. These lower costs, in turn, stimulate
greater production. Figure 8 illustrates this process by an
outward shift of the aggregate supply curve”from S0S0 to
the brick-colored curve S1S1.
C As the figure shows, the outward shift of the aggregate
S1 supply curve brought on by the recession pushes equilib-
rium output up as the economy moves from point A to
point B. Thus, the size of the recessionary gap begins to
shrink. This process continues until the aggregate supply
Real GDP
curve reaches the position indicated by the blue curve S2S2

The dollar and imports will be discussed in detail in Chapter 19.

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Licensed to:

Chapter 16 323
The Trade-Off between Inflation and Unemployment

in Figure 8. Here wages have fallen enough to
eliminate the recessionary gap, and the econ- f
omy has reached a full-employment equilib- d
rium at point C.2
We can relate this sequence of events to our 6
discussion of the origins of the Phillips curve

Inflation Rate
with the help of Figure 9, which is a hypothetical
Phillips curve. Point a in Figure 9 corresponds to 4
point A in Figure 8: It shows the initial recession- a
ary gap with unemployment (assumed to be 6.5
percent) above full employment, which we as- c
sume to occur at 5 percent.
But we have just seen that point A in Figure 8”
and therefore also point a in Figure 9”is not
3.5 4 4.5 5 5.5 6 6.5 7
sustainable. The economy tends to rid itself of
the recessionary gap through the disinflation Unemployment Rate in Percent
process just described. The adjustment path from
A to C depicted in Figure 8 would appear on our F I GU R E 9
Phillips curve diagram as a movement toward less inflation and less unemployment” The Vertical Long-Run
something like the blue arrow from point a to point c in Figure 9. Phillips Curve
Similarly, points representing inflationary gaps”such as point d in Figure 9”are also not
sustainable. They, too, are gradually eliminated by the self-correcting mechanism that we
studied in Chapter 10. Wages are forced up by the abnormally low unemployment, which
in turn pushes prices higher. Higher prices deter investment spending by forcing up interest
rates, and they deter consumer spending by lowering the purchasing power of consumer
wealth. The inflationary process continues until the amount people want to buy is brought
into line with the amount firms want to sell at normal full employment. During such an ad-
justment period, unemployment and inflation both rise”as indicated by the blue arrow
from point d to point f in Figure 9. Putting these two conclusions together, we see that
On a Phillips curve diagram such as Figure 9, neither points corresponding to an infla- The economy™s self-
tionary gap (like point d) nor points corresponding to a recessionary gap (like point a) correcting mechanism
can be maintained indefinitely. Inflationary gaps lead to rising unemployment and ris- always tends to push the
unemployment rate back
ing inflation. Recessionary gaps lead to falling inflation and falling unemployment.
toward a specific rate of
All the points that are sustainable in the long run (such as c, e, and f), therefore, corre- unemployment that we call
spond to the same rate of unemployment, which is therefore called the natural rate of the natural rate of
unemployment. The natural rate corresponds to what we have so far been calling the
“full-employment” unemployment rate. The vertical (long-run)
Thus, the Phillips curve connecting points d, e, and a is not a menu of policy choices Phillips curve shows
at all. Although we can move from a point such as e to a point such as d by stimulating the menu of inflation/
aggregate demand sufficiently, the economy will not be able to remain at d. We cannot unemployment choices
available to society in the
keep unemployment at such a low level indefinitely. Instead, policy makers must
long run. It is a vertical
choose from among points such as c, e, and f, all of which correspond to the same “natu-
straight line at the natural
ral” rate of unemployment. For obvious reasons, the line connecting these points has
rate of unemployment.
been dubbed the vertical long-run Phillips curve. It is this vertical Phillips curve, con-
necting points such as e and f, that represents the true long-run menu of policy choices.
We thus conclude:
ble to “ride up the Phillips curve” toward lower levels of unemployment by stimulating
aggregate demand. (See, for example, point d in Figure 9.) Conversely, by restricting the
growth of demand, it is possible to “ride down the Phillips curve” toward lower rates of BEYOND THE

2 This simple analysis assumes that the aggregate demand curve does not move during the adjustment period. If
it is shifting to the right, the recessionary gap will disappear even faster, but inflation will not slow down as
much. (Exercise: Construct the diagram for this case by adding a shift of the aggregate demand curve to Figure 8.)

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 3
324 Fiscal and Monetary Policy

inflation (such as point a in Figure 9). Thus, there is a short run trade-off between unem-
ployment and inflation. Stimulating demand will improve the unemployment picture but
worsen inflation; restricting demand will lower inflation but aggravate the unemployment
However, there is no such trade-off in the long run. The economy™s self-correcting


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