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

A Recovery Phase

The stagflation phase shown in Figure 16.7 "A Stagflation Phase" leaves the economy with a recessionary gap at point 4 in Panel (a). The economy is bumped into a recession by changing expectations. Policy makers can be expected to respond to a recessionary gap by boosting aggregate demand. That increase in aggregate demand will lead the economy into a recovery phase.

Figure 16.8 "The Recovery Phase" illustrates a recovery phase. In Panel (a), aggregate demand increases to AD₅, boosting the price level to 1.09 and real GDP to $1,060. The new price level represents a 1.4% ([1.09 − 1.075] / 1.075 = 1.4%) increase over the previous price level. The price level is higher, but the inflation rate has fallen sharply. Meanwhile, the increase in real GDP cuts the unemployment rate to 3.0%, shown by point 5 in Panel (b).

Figure 16.8 The Recovery Phase

Policy makers act to increase aggregate demand in order to move the economy out of a recessionary gap created during a stagflation phase. Here, aggregate demand shifts to AD₄, boosting the price level to 1.09 and real GDP to $1,060 billion at point 5 in Panel (a). The increase in real GDP reduces unemployment. The price level has risen, but at a slower rate than in the previous period. The result is a reduction in inflation. The new combination of unemployment and inflation is shown by point 5 in Panel (b).

Policies that stimulate aggregate demand and changes in expected price levels are not the only forces that affect the values of inflation and unemployment. Changes in production costs shift the short-run aggregate supply curve. Depending on when these changes occur, they can reinforce or reduce the swings in inflation and unemployment. For example, Figure 16.4 "Connecting the Points: Inflation and Unemployment" shows that inflation was exceedingly low in the late 1990s. During this period, oil prices were very low – only $12.50 per barrel in 1998, for example. In terms of Figure 16.7 "A Stagflation Phase", we can represent the low oil prices by a short-run aggregate supply curve that is to the right of SRAS_4,5. That would mean that output would be somewhat higher, unemployment somewhat lower, and inflation somewhat lower than what is shown as point 5 in Panels (a) and (b) of Figure 16.8 "The Recovery Phase".