25-The Unemployment/Inflation Tradeoff

  1. Economist A. W. Phillips graphed British annual unemployment data contrasted against inflation data over a 60 year period and realized a certain relationship where unemployment and inflation were interrelated and could be depicted graphically and was named the Phillips Curve.
    1. With unemployment on the horizontal axis and inflation on the vertical axis, the top left portion of the graph would represent high inflation and low unemployment, whereas the bottom right would represent low inflation and high unemployment
    2. Why is there a tradeoff?
      1. If aggregate demand and aggregate supply meet at potential GDP and then aggregate demand then further increases, Unemployment would remain low but inflation would be high as too few dollars would be chasing too many goods
      2. Conversely, if it were at potential GDP and aggregate demand is lower, then unemployment is much more of a risk with not much chance of inflation.
  2. In the U.S. this curve worked well when first used for data from the 1950’s and 60’s, however subsequent decades would challenge the curves validity
    1. In 1968 both Milton Friedman and Edmund Phelps researched and concluded that the curve would not hold up in the long run arguing that the economy would eventually revert to the natural rate of unemployment and inflation would work independently.
    2. In the 70’s both inflation and unemployment were high, in the 80’s they were low and in the 90’s both were very low



      Screen clipping taken: 6/24/2011, 2:57 PM



    3. Which made most economists conclude that the Phillips curve is more of a short term phenomena
    4. In the chart below it shows that across decades operating at about the same unemployment level inflation would work independently




      Screen clipping taken: 6/24/2011, 2:55 PM



    5. As seen above the “Phillips Curve” would be nothing more than a straight vertical line, representing no tradeoff
  3. Different views of the unemployment-inflation tradeoff see major differences between Keynesian and Neo-classical economists
    1. Keynesians fear the macro economy is subject to a failure to reconcile aggregate demand and supply
      1. Keynesians fear that the economy is inherently unstable as investments and consumption move sharply but because of sticky wages and prices, both the labor and product markets may not adjust to equilibrium quickly
      2. Keynesians also believe that if markets are to be left alone in response to disturbances we would be stuck below potential GDP with high unemployment for a long time
      3. And to actively control the markets they advocate active Governments
    2. Neo-classics believe that over time markets do adjust toward potential GDP arguing that once prices get low enough, that would in turn stimulate demand
      1. Neo-classics believe that if government interferes they have just as much chance of doing harm than of doing good
      2. If, however, the Gov’t does decide to interfere they should do so with clear cut rules so that markets can account for them
    3. Both Keynesians and neo-classics believe in the natural rate of unemployment and will look to redesign institutions to even lower that rate. However, Keynesians would use the Gov’t to actively stimulate the economy to accomplish its goals, whereas neo-classics would prefer deregulation
    4. Keynesians focus more on unemployment and neo-classics focus more on inflation
      1. Low inflation clearly lays a better groundwork for investing
      2. Low unemployment, Keynes would say, is a form of investing in human capital and experience
    5. Certain things they may agree upon are that
      1. Economic growth in the long run is what matters, but a country should seek to minimize the extremes of cycles and avoid either high unemployment or high inflation
      2. Differences come down mostly to political judgments about the effectiveness of Gov’t and which macroeconomic goals should be viewed as most important(e.g. unemployment, inflation, and long-term growth)
      3. Both schools use the aggregate supply and aggregate demand to argue their case

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