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.

2. Explaining Inflation–Unemployment Relationships

LEARNING OBJECTIVE

  1. Use the model of aggregate demand and aggregate supply to explain a Phillips phase, a stagflation phase, and a recovery phase.

We have examined the inflation and unemployment experience in the United States during the past half century. Our task now is to explain it. We will apply the model of aggregate demand and aggregate supply, along with our knowledge of monetary and fiscal policy, to explain just why the economy performed as it did. We will find that the relationship between inflation and unemployment depends crucially on events, macroeconomic policy, and expectations.

The next three sections discuss the pattern that unfolded from the 1970s through the 1990s in which stagflation and then recovery followed Phillips phases. We will also look at the behavior of the economy in the first decade of the 21st century. Each phase results from a specific pattern of shifts in the aggregate demand and short-run aggregate supply curves.

It is important to be careful in thinking about the meaning of changes in inflation as we examine the cycle of inflation and unemployment. The rise in inflation during a Phillips phase does not simply mean that the price level rises. It means that the price level rises by larger and larger percentages. Rising inflation means that the price level is rising at an increasing rate. In a recovery phase, a falling rate of inflation does not imply a falling price level. It means the price level is rising, but by smaller and smaller percentages. Falling inflation means that the price level is rising more slowly, not that the price level is falling.