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mechanism ensures that unemployment will eventually return to the natural rate no
matter what happens to aggregate demand. In the long run, faster growth of demand
leads only to higher inflation, not to lower unemployment; and slower growth of
demand leads only to lower inflation, not to higher unemployment.




FIGHTING UNEMPLOYMENT WITH FISCAL AND MONETARY POLICY
Now let us apply this analysis to a concrete policy problem”one that has often troubled
policy makers in the United States and in many other countries. Should the government
use its ability to manage aggregate demand through fiscal and monetary policy to combat
unemployment? And if so, how? To focus the discussion, we will deal with a recent, real-
world example.
The unemployment rate in the United States bottomed out at 3.8 percent in April 2000,
a rate that most economists thought was well below the natural rate of unemployment
(something like point d in Figure 9). It then began to creep up gradually, and by August
2001 stood at 4.9 percent”which may be close to the natural rate (see point e in the
figure). Then the terrorist attacks of September 11, 2001 occurred, and within a few
months unemployment had risen to 5.7 percent. By December, the economy was in a
position resembling point a in Figure 9, with a recessionary gap.
Even if fiscal and monetary policy makers did nothing, the economy™s self-correcting
mechanism would have gradually eroded the recessionary gap. Both unemployment and
inflation would have declined gradually as the economy moved along the blue arrow
from point a to point c in Figure 9. Eventually, as the diagram shows, the economy would
have returned to its natural rate of unemployment (assumed here to be 5 percent) and
inflation would have fallen”in the example, from 3 percent to 2 percent.
This eventual outcome is quite satisfactory: Both unemployment and inflation are lower
at the end of the adjustment period (point c) than at the beginning (point a). But it may take
an agonizingly long time to get there. And American policy makers in 2001 did not view
patience as a virtue. Rather than keep hands off, the Federal Reserve started cutting inter-
est rates almost immediately after the terrorist attacks. Fiscal policy reacted as well. Spend-
ing on defense and security was increased immediately after the attacks, the first phase of
the 2001 tax cut kicked in, and Congress passed a small fiscal stimulus package.
According to the theory we have learned, such a large dose of expansionary fiscal and
monetary policy should push the economy up the short-run Phillips curve from a point
like a toward a point like e in Figure 9. Compared to simply relying on the self-correcting
mechanism, then, the strong policy response presumably led to a faster recovery from the
2001 recession”which was certainly the intent of the president, Congress, and the Fed.
But Figure 9 points out that it also probably left us with a higher inflation rate (5 percent
in the figure, about 2 percent in reality).
This example illustrates the range of choices open to policy makers. They can wait pa-
tiently while the economy™s self-correcting mechanism pulls unemployment down to the
natural rate”leading to a long-run equilibrium like point c in Figure 9. Or they can rush
the process along with expansionary monetary and fiscal policy”and wind up with the
same unemployment rate but higher inflation (point e). In what sense, then, do policy
makers face a trade-off between inflation and unemployment? The answer, illustrated by
this diagram, is
The cost of reducing unemployment more rapidly by expansionary fiscal and monetary
policies is a permanently higher inflation rate.




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Chapter 16 325
The Trade-Off between Inflation and Unemployment



WHAT SHOULD BE DONE?
Should the government pay the inflationary costs of fighting unemployment? When the
transitory benefit (lower unemployment for a while) is balanced against the permanent
cost (higher inflation), have we made a good bargain?
We have noted that the U.S. government opted for a strong policy response in 2001. Thus
two forces were at work simultaneously: The self-correcting mechanism was pulling
the economy toward point c in Figure 9, and expansionary monetary and fiscal policies were
pushing it toward point e. The net result was an intermediate path”something like the
dotted line leading to point g in Figure 9. As the economy returned to full employment over
the years from 2003 to 2006, growth was reasonably strong and inflation rose only a little.
How do policy makers make decisions like this? Our analysis highlights three critical
issues on which the answer depends.


The Costs of Inflation and Unemployment
In Chapter 6, we examined the social costs of inflation and unemployment. Many of the
benefits of lower unemployment are readily measured in dollars and cents. Basically, we
need only estimate how much higher real GDP is each year. However, the costs of the per-
manently higher inflation rate are more difficult to measure. So there is considerable contro-
versy over the costs and benefits of using demand management to fight unemployment.
Economists and political leaders who believe that inflation is extremely costly may
deem it unwise to accept the inflationary consequences of reducing unemployment faster.
And indeed, a few dissenters in both 2001 and 2007 (when the Fed once again cut interest
rates to stave off recession) were worried about future inflation. Most U.S. policy makers
apparently disagreed with that view, however. They decided that reducing unemploy-
ment was the higher priority. But things do not always work out that way. In recent
decades, European authorities have often avoided expansionary stabilization policies, and
allowed unemployment to remain high, rather than accept even slightly higher inflation.


The Slope of the Short-Run Phillips Curve
The shape of the short-run Phillips curve is also critical. Look back at Figure 9, and imag-
ine that the Phillips curve connecting points a, e, and d was much steeper. In that case, the
inflationary costs of using expansionary policy to reduce unemployment would be more
substantial. By contrast, if the short-run Phillips curve was much flatter than the one
shown in Figure 9, unemployment could be reduced with less inflationary cost.


The Efficiency of the Economy™s Self-Correcting Mechanism
We have emphasized that once a recessionary gap opens, the economy™s natural self-
correcting mechanism will eventually close it”even in the absence of any policy response.
The obvious question is: How long must we wait? If the self-correcting mechanism”which
works through reductions in wage inflation”is fast and reliable, high unemployment will
not last very long. So the costs of waiting will be small. But if wage inflation responds only
slowly to unemployment, the costs of waiting may be enormous. That has evidently been
true in much of Europe, where unemployment has remained persistently high for years.
The efficacy of the self-correcting mechanism is also surrounded by controversy. Most
economists believe that the weight of the evidence points to extremely sluggish wage behav-
ior: Wage inflation appears to respond slowly to economic slack. In terms of Figure 9, this lag
means that the economy will traverse the path from a to c at an agonizingly slow pace, so that
a long period of weak economic activity will be necessary to bring down inflation.
But a significant minority opinion finds this assessment far too pessimistic. Economists
in this group argue that the costs of reducing inflation are not nearly so severe and that




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Part 3
326 Fiscal and Monetary Policy




Inflation Targeting and the Phillips Curve
Knowing the proper policy with certainty is, of course, out of
In Chapter 14, we mentioned inflation targeting as a new approach
the question. But a central bank can use a model similar to the ag-
to monetary policy that is gaining adherents in many countries. In
gregate supply/demand model taught in this book to estimate how
practice, inflation targeting requires monetary policy makers to rely
its policy choices will affect the unemployment rate, say, this year
heavily on the Phillips curve. Why? Because a central bank with,
and next. Then it can use a Phillips curve to estimate how that un-
say, a 2 percent inflation target is obligated to pursue a monetary
employment path will affect inflation. In fact, that is more or less
policy that it believes will drive the inflation rate to 2 percent after,
what inflation-targeting central banks from New Zealand to
say, a year or two. But how does the central bank know which pol-
Norway now do.
icy will accomplish this goal?




the key to a successful anti-inflation policy is how it affects people™s expectations of
inflation. To understand this argument, we must first understand why expectations are
relevant to the Phillips curve.




INFLATIONARY EXPECTATIONS AND THE PHILLIPS CURVE
Recall from Chapter 10 that the main reason the economy™s aggregate supply curve slopes
upward”that is, why output increases as the price level rises”is that businesses typically
purchase labor and other inputs under long-term contracts that fix input costs in money
terms. (The money wage rate is the clearest example.) As long as such contracts are in
force, real wages fall as the prices of goods rise. Labor therefore becomes cheaper in real
terms, which persuades businesses to expand employment and output. Buying low and
selling high is, after all, the route to higher profits.
TA BL E 1 Table 1 illustrates this general idea in a concrete example. We sup-
Money and Real Wages under Unexpected pose that workers and firms agree today that the money wage to be
Inflation
paid a year from now will be $10 per hour. The table then shows the
Price Level Wage per Real Wage real wage corresponding to each alternative inflation rate. For example,
Inflation 1 Year Hour 1 Year per Hour if inflation is 4 percent, the real wage a year from now will be
Rate from Now from Now 1 Year from Now $10.00/1.04 5 $9.62. Clearly, the higher the inflation rate, the higher the
price level at the end of the year and the lower the real wage.
0% 100 $10.00 $10.00
2 102 10.00 9.80 Lower real wages provide an incentive for firms to increase output,
4 104 10.00 9.62 as we have just noted. But lower real wages also impose losses of pur-
6 106 10.00 9.43
chasing power on workers. Thus, workers are, in some sense,
“cheated” by inflation if they sign a contract specifying a fixed money
NOTE: Each real wage figure is obtained by dividing the $10
nominal wage by the corresponding price level a year later
wage in an inflationary environment.
and multiplying by 100. Thus, for example, when the inflation
rate is 4 percent, the real wage at the end of the year is
Many economists doubt that workers will sign such contracts if
($10.00/104) 3 100 5 $9.62.
they can see inflation coming. Wouldn™t it be wiser, these economists
ask, to insist on being compensated for the coming inflation? After
TA BL E 2
all, firms should be willing to offer higher money wages if they ex-
Money and Real Wages under Expected Inflation
pect inflation, because they realize that higher money wages need
Expected Expected Real not imply higher real wages.
Expected Price Level Wage per Wage per Table 2 illustrates the mechanics of such a deal. For example, if
Inflation 1 Year Hour 1 Year Hour 1 Year people expect 4 percent inflation, the contract could stipulate that
Rate from Now from Now from Now
the wage rate be increased to $10.40 (which is 4 percent more than
0% 100 $10.00 $10.00 $10) at the end of the year. That would keep the real wage at $10
2 102 10.20 10.00
(because $10.40/1.04 5 $10.00), the same as it would be under zero
4 104 10.40 10.00
inflation. The other money wage figures in Table 2 are derived
6 106 10.60 10.00
similarly.



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Licensed to:

Chapter 16 327
The Trade-Off between Inflation and Unemployment



If workers and firms behave this way, and if they forecast inflation accurately, then the
real wage will remain unchanged as the price level rises. (Notice that, in Table 2, the ex-
pected future real wage is $10 per hour regardless of the expected inflation rate.) Prices
and wages will go up together. So workers will not lose from inflation, and firms will not
gain. But then there is no reason for firms to raise production when the price level rises. In
a word, the aggregate supply curve becomes vertical. In general:
If workers can see inflation coming, and if they receive compensation for it, inflation does
not erode real wages. But if real wages do not fall, firms have no incentives to increase
production. In such a case, the economy™s aggregate supply curve will not slope upward,
but, rather, will be a vertical line at the level of output corresponding to potential GDP.
Such a curve is shown in Panel (a) of Figure 10. Because a vertical aggregate supply
curve leads to a vertical Phillips curve, it follows that even the short-run Phillips curve
would be vertical under these circumstances, as in Panel (b) of Figure 10.3
If this analysis is correct, it has profound implications for the costs and benefits of fight-
ing inflation. To see this, refer once again to Figure 9 (page 323), but now use the graph to
depict the strategy of fighting inflation by causing a recession. Suppose we start at point e,
with 5 percent inflation. To move to point c (representing 2 percent inflation), the econ-
omy must take a long and unpleasant detour through point a. Specifically, contractionary
policies must push the economy down the Phillips curve toward point a before the self-
correcting mechanism takes over and moves the economy from a to c. In words, we must
suffer through a recession to reduce inflation.
But what if even the short-run Phillips curve were vertical rather than downward-
sloping? In this case, the unpleasant recessionary detour would not be necessary. Instead,
inflation could fall without unemployment rising. The economy could move vertically
downward from point e to point c.
Does this optimistic analysis describe the real world? Can we really slay the inflation-
ary dragon so painlessly? Not necessarily, for our discussion of expectations so far has
made at least one unrealistic assumption: that businesses and workers can predict infla-
tion accurately. Under this assumption, as Table 2 shows, real wages are unaffected by
inflation”leaving the aggregate supply curve vertical, even in the short run.
But forecasts of inflation are often inaccurate. Suppose workers underestimate infla-
tion. For example, suppose they expect 4 percent inflation but actually get 6 percent. Then


FIGURE 10
S
A Vertical Aggregate
Supply Curve and the
Corresponding Vertical
Phillips Curve
Inflation Rate
Price Level




Vertical Vertical
aggregate short-run
supply Phillips
curve curve




S 5
Real GDP Unemployment Rate
(a) (b)

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