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.

3. Inflation and Unemployment in the Long Run

Unemployment and the Phillips Curve in the Long Run

Economists distinguish three types of unemployment: frictional unemployment, structural unemployment, and cyclical unemployment. The first two exist at all times, even when the economy operates at its potential. These two types of unemployment together determine the natural rate of unemployment. In the long run, the economy will operate at potential, and the unemployment rate will be the natural rate of unemployment. For this reason, in the long run the Phillips curve will be vertical at the natural rate of unemployment. Thus, the long-run Phillips curve is a vertical line at the natural rate of unemployment, showing that in the long run, there is no trade-off between inflation and unemployment. Figure 16.10 "The Phillips Curve in the Long Run" explains why. Suppose the economy is operating at YP on AD1 and SRAS1. Suppose the price level is P0, the same as in the last period. In that case, the inflation rate is zero. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. Now suppose that the aggregate demand curve shifts to AD2. In the short run, output will increase to Y1. The price level will rise to P1, and the unemployment rate will fall to U1. In Panel (b) we show the new unemployment rate, U1, to be associated with an inflation rate of π1, and the beginnings of the negatively sloped short-run Phillips curve emerges. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2 and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the long-run, the Phillips curve is vertical.

Figure 16.10 The Phillips Curve in the Long Run

Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with price level of P0, the same as in the last period. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. If the aggregate demand curve shifts to AD2, in the short run output will increase to Y1, and the price level will rise to P1. In Panel (b), the unemployment rate will fall to U1, and the inflation rate will be π1. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2, and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the long-run, the Phillips curve is vertical.

An economy operating at its potential would have no cyclical unemployment. Because an economy achieves its potential output in the long run, an analysis of unemployment in the long run is an analysis of frictional and structural unemployment. In this section, we will also look at some new research that challenges the very concept of an economy achieving its potential output.