Inflation and Unemployment

Read this chapter to examine the relationship between inflation and unemployment. As you will see, while there have been some periods in which a trade-off exists between inflation and unemployment, there are also periods in which such clear-cut negative relationship between these variables falls apart. The chapter offers some explanations for these variable behaviors and the stabilization policies that are used to address undesirable trends in the variables.

1. Relating Inflation and Unemployment

Case in Point: Some Reflections on the 1970s

Looking back, we may find it difficult to appreciate how stunning the experience of 1970 and 1971 was. But those two years changed the face of macroeconomic thought.

Introductory textbooks of that time contained no mention of aggregate supply. The model of choice was the aggregate expenditures model. Students learned that the economy could be in equilibrium below full employment, in which case unemployment would be the primary macroeconomic problem. Alternatively, equilibrium could occur at an income greater than the full employment level, in which case inflation would be the main culprit to worry about.

These ideas could be summarized using a Phillips curve, a new analytical device. It suggested that economists could lay out for policy makers a menu of possibilities. Policy makers could then choose the mix of inflation and unemployment they were willing to accept. Economists would then show them how to attain that mix with the appropriate fiscal and monetary policies.

Then 1970 and 1971 came crashing in on this well-ordered fantasy. President Richard Nixon had come to office with a pledge to bring down inflation. The consumer price index had risen 4.7% during 1968, the highest rate since 1951. Mr. Nixon cut government purchases in 1969, and the Fed produced a sharp slowing in money growth. The president's economic advisers predicted at the beginning of 1970 that inflation and unemployment would both fall. Appraising the 1970 debacle early in 1971, the president's economists said that the experience had not been consistent with what standard models would predict. The economists suggested, however, that this was probably due to a number of transitory factors. Their forecast that inflation and unemployment would improve in 1971 proved wide of the mark – the unemployment rate rose from 4.9% to 5.9% (an increase of 20%), while the rate of inflation measured by the change in the implicit price deflator barely changed from 5.3% to 5.2%.

As we will see, the experience can be readily explained using the model of aggregate demand and aggregate supply. But this tool was not well developed then. The experience of the 1970s forced economists back to their analytical drawing boards and spawned dramatic advances in our understanding of macroeconomic events. We will explore many of those advances in the next chapter.