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training”if, indeed, the jobs ever existed.
Second, the high cost of these programs restricts the number of workers who can be ac-
commodated, even in successful programs. For this reason, publicly supported job train-
ing is done on a very small scale in the United States”much less than in most European
countries. Small expenditures can hardly be expected to make a large dent in the natural
rate of unemployment.
But many observers believe the natural rate of unemployment has fallen in the United
States despite these problems. Why? One reason is that work experience has much in com-
mon with formal training”workers become more productive by learning on the job. As

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Part 3
332 Fiscal and Monetary Policy

the American workforce has aged, the average level of work experience has increased,
which, according to many economists, has lowered the natural rate of unemployment.
(For some other possible reasons, see “Why Did the Natural Rate of Unemploy-
ment Fall?”)

Indexing”which refers to provisions in a law or contract that automatically adjust mone-
Indexing refers to provi-
sions in a law or a contract tary payments whenever a specific price index changes”presents a very different
whereby monetary pay- approach to the inflation-unemployment dilemma. Instead of trying to improve the terms
ments are automatically ad-
of the trade-off, indexing seeks to reduce the social costs of inflation.
justed whenever a specified
The most familiar example of indexing is an escalator clause in a wage agreement. Es-
price index changes. Wage
calator clauses provide for automatic increases in money wages”without the need for
rates, pensions, interest
new contract negotiations”whenever the price level rises by more than a specified
payments on bonds, in-
amount. Such agreements thus act to protect workers partly from inflation. Nowadays,
come taxes, and many
other things can be indexed with inflation low and stable, relatively few workers are covered by escalator clauses. But
in this way, and have been. they were far more common when inflation was higher.
Sometimes such contractual
Interest payments on bonds or bank accounts can also be indexed, and the U.S. gov-
provisions are called escala-
ernment began doing so with a small fraction of its bonds in 1997. The most extensive
tor clauses.
indexing to be found in the United States today, however, appears in government trans-
fer payments. Social Security benefits, for instance, are indexed so that retirees are not
victimized by inflation.
Some economists believe that the United States should follow the example of several
foreign countries and adopt a more widespread indexing system. Why? Because, they ar-
gue, it would take most of the sting out of inflation. To see how, let us review some of the
social costs of inflation that we enumerated in Chapter 6.
One important cost is the capricious redistribution of income caused by unexpected in-
flation. We saw that borrowers and lenders normally incorporate an inflation premium
equal to the expected rate of inflation into the nominal interest rate. Then, if inflation turns
out to be higher than expected, the borrower has to pay the lender only the agreed-on
nominal interest rate, including the premium for expected inflation; he does not have to
compensate the lender for the (higher) actual inflation. Thus, the borrower enjoys a wind-
fall gain and the lender loses out. The opposite happens if inflation turns out to be lower
than expected.

Why Did the Natural Rate of Unemployment Fall?
In 1995, most economists believed that the natural rate of unemploy- Economists do not have a complete answer to this question, but
ment in the United States was approximately 6 percent”and certainly a few pieces of the puzzle are understood. For one thing, the U.S.
not lower than 5.5 percent. If unemployment fell below that critical working population aged”and mature workers are normally unem-
rate, they said, inflation would start to rise. Experience in the late 1990s ployed less often than are young workers. The rise of temporary-
belied that view. The unemployment rate dipped below 5.5 percent in help agencies and Internet job searching capabilities helped match
the summer of 1996”and kept on falling. By the end of 1998, it was workers to jobs better. Ironically, record-high levels of incarceration
below 4.5 percent. For a few months in 2001, it even dipped below probably reduced unemployment, too, because many of those in
4 percent. And still there were no signs of rising inflation. jail would otherwise have been unemployed. It is also believed
One reason for such amazing macroeconomic performance was (though difficult to prove) that the weak labor markets of the early
discussed in this chapter: A series of favorable supply shocks 1990s left labor more docile, thereby driving down the unemploy-
pushed the aggregate supply curve outward at an unusually rapid ment rate consistent with constant inflation.
pace. But it also appears that the natural rate of unemployment fell Whatever the reasons, it does appear that the United States can
in the 1990s. Why? now sustain a lower unemployment than it could, say, 15 years ago.

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Chapter 16 333
The Trade-Off between Inflation and Unemployment

But if interest rates on loans were indexed, none of this would occur. Borrowers and
lenders would agree on a fixed real rate of interest, and the borrower would compensate
the lender for whatever actual inflation occurred. No one would have to guess what the
inflation rate would be.6
A second social cost mentioned in Chapter 6 stems from the fact that our tax system
levies taxes on nominal interest and nominal capital gains. As we learned, this flaw in the
tax system leads to extremely high effective tax rates in an inflationary environment. But
indexing can cure this problem. We need only rewrite the tax code so that only real inter-
est payments and real capital gains are taxed.
In the face of all these benefits, why does our economy not employ more indexing? One
obvious reason is that inflation has been low for years. Indexing received much more
attention years ago, when inflation was much higher. A second reason is that some econo-
mists fear that indexing will erode society™s resistance to inflation. With the costs of infla-
tion so markedly reduced, they ask, what will stop governments from inflating more and
more? They fear that the answer is: Nothing. Voters who stand to lose nothing from infla-
tion are unlikely to pressure their legislators into stopping it. Opponents of indexing
worry that a mild inflationary disease could turn into a ravaging epidemic in a highly
indexed economy.

1. Inflation can be caused either by rapid growth of aggre- shape of the short-run Phillips curve, and the speed at
gate demand or by sluggish growth of aggregate supply. which inflationary expectations are adjusted.
2. When fluctuations in economic activity emanate from 8. If workers expect inflation to occur, and if they demand
the demand side, prices will rise rapidly when real out- (and receive) compensation for inflation, output will be
put grows rapidly. Because rapid growth means more independent of the price level. Both the aggregate sup-
jobs, unemployment and inflation will be inversely ply curve and the short-run Phillips curve are vertical in
related. this case.
3. This inverse relationship between unemployment and 9. Errors in predicting inflation will change real wages and
inflation is called the Phillips curve. In the United therefore the quantity of output that firms wish to sup-
States, data for the 1950s and 1960s display a clear ply. Thus, unpredicted movements in the price level will
Phillips-curve relation, but data for the 1970s and 1980s lead to a normal, upward-sloping aggregate supply
do not. curve.
4. The Phillips curve is not a menu of long-run policy 10. According to the rational expectations hypothesis,
choices for the economy, because the self-correcting errors in predicting inflation are purely random. As a
mechanism guarantees that neither an inflationary gap consequence, except for some random gyrations, the ag-
nor a recessionary gap can last indefinitely. gregate supply curve is vertical even in the short run.
5. Because of the self-correcting mechanism, the econ- 11. Many economists reject the rational expectations view.
omy™s true long-run choices lie along a vertical long-run Some deny that expectations are “rational” and believe
Phillips curve, which shows that the so-called natural instead that people tend, for example, to underpredict
rate of unemployment is the only unemployment rate inflation when it is rising. Others point out that con-
that can persist indefinitely. tracts signed years ago may not embody expectations
that are “rational” in terms of what we know today.
6. In the short run, the economy can move up or down
along its short-run Phillips curve. Temporary reductions 12. When fluctuations in economic activity are caused by
in unemployment can be achieved at the cost of higher shifts of the aggregate supply curve, output will grow
inflation, and temporary increases in unemployment slowly (causing unemployment to rise) when inflation
can be used to fight inflation. This short-run trade-off rises. Hence, the rates of unemployment and inflation
between inflation and unemployment is one of our will be positively correlated. Many observers feel that
Ideas for Beyond the Final Exam. this sort of stagflation is why the Phillips curve
collapsed in the 1970s. Similarly, a series of favorable
7. Whether it is advisable to use unemployment to fight
supply shocks help explain the 1990s combination of
inflation depends on four principal factors: the relative
low inflation and strong economic growth.
social costs of inflation versus unemployment, the effi-
ciency of the economy™s self-correcting mechanism, the

For example, an indexed loan with a 2 percent real interest rate would require a 5 percent nominal interest

payment if inflation were 3 percent, a 7 percent nominal interest payment if inflation were 5 percent, and so on.

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Part 3
334 Fiscal and Monetary Policy

13. Even if inflation is initiated by supply-side problems, so 14. Policies that improve the functioning of the labor
that inflation and unemployment rise together, the mon- market”including retraining programs and employ-
etary and fiscal authorities still face this trade-off: Any- ment services”can, in principle, lower the natural rate of
thing they do to improve unemployment is likely to unemployment. To date, however, the U.S. government
worsen inflation, and anything they do to reduce infla- has enjoyed only modest success with these measures.
tion is likely to aggravate unemployment. (This is part 15. Indexing is another way to approach the trade-off
of one of our Ideas for Beyond the Final Exam.) The reason problem. Instead of trying to improve the trade-off, it con-
is that monetary and fiscal policy mainly influence the centrates on reducing the social costs of inflation.
aggregate demand curve, not the aggregate supply Opponents of indexing worry, however, that the econ-
curve. omy™s resistance to inflation may be lowered by indexing.

Demand-side inflation 318 Natural rate of Rational expectations 328
unemployment 323
Supply-side inflation 318 Indexing 332
Vertical (long-run) Phillips
Phillips curve 319 Real versus nominal interest
curve 323 rates 333
Stagflation caused by supply
Trade-off between unemployment
shocks 321
and inflation in the short run and
Self-correcting mechanism 322
in the long run 323

1. Show that if the economy™s aggregate supply curve is yours in for an indexed bond that paid a 3 percent real
vertical, fluctuations in the growth of aggregate demand rate of interest? What if the real interest rate offered
produce only fluctuations in inflation with no effect on were 2 percent? What if it were 1 percent? What do your
output. answers to these questions reveal about your personal
attitudes toward inflation?
2. Long-term government bonds now pay approximately
5 percent nominal interest. Would you prefer to trade

1. When inflation and unemployment fell together in the 5. Explain why expectations of inflation affect the wages
1990s, some observers claimed that policy makers no that result from labor-management bargaining.
longer faced a trade-off between inflation and unem- 6. What is meant by “rational” expectations? Why does the
ployment. Were they correct? hypothesis of rational expectations have such stunning
2. “There is no sense in trying to shorten recessions implications for economic policy? Would believers in ra-
through fiscal and monetary policy because the effects of tional expectations want to shorten a recession by ex-
these policies on the unemployment rate are sure to be panding aggregate demand? Would they want to fight
temporary.” Comment on both the truth of this state- inflation by reducing aggregate demand? Relate this
ment and its relevance for policy formulation. analysis to your answer to Test Yourself Question 1.
3. Why is it said that decisions on fiscal and monetary pol- 7. It is often said that the Federal Reserve Board typically
icy are, at least in part, political decisions that cannot be cares more about inflation and less about unemploy-
made on “objective” economic criteria? ment than the administration. If this is true, why might
presidents often worry about what the Fed might do to
4. What is a Phillips curve? Why did it seem to work so
interest rates?
much better in the period from 1954 to 1969 than it did
in the 1970s?

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Chapter 16 335
The Trade-Off between Inflation and Unemployment

8. The year 2007 closed with the unemployment rate b. Give one or more arguments for engaging in con-
around 5 percent, real GDP barely growing, inflation tractionary monetary or fiscal policies under these
above 2 percent and apparently rising a bit, and the fed- circumstances.
eral budget showing a large deficit. c. Which arguments do you find more persuasive?
a. Give one or more arguments for engaging in expan-
sionary monetary or fiscal policies under these

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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:


The United States in the
World Economy

G lobalization” became a buzzword in the 1990s”and it remains one today. Some
people extol its virtues and view it as something to be encouraged. Others deplore
its (real or imagined) costs and seek to stop globalization in its tracks. For example,
globalization is often viewed as a threat to the livelihoods of American workers.
We will examine several aspects of the globalization debate in Part 4. But love it or hate


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