Chapter 35: The Short-Run Trade-off Between
Inflation and Unemployment
We discussed the long-run determinants of unemployment and inflation. We saw that the
natural rate of unemployment depends on things in the labor market such as minimum wage
laws, the market power of unions, the role of efficiency wages and the effectiveness of job
search. By contrast, the inflation rate depends primarily on growth in the money supply,
which a nation’s central bank controls. In the long run, therefore inflation and unemployment
are largely unrelated problems. In the short-run, the situation is very different.
The links between the rate of increase in wages and inflation are part of the short-run cause
of inflation referred to as cost-push inflation. Cost-push inflation occurs where firms face
higher costs and pass these on in the form of higher prices. Wages are one of the most
important costs of facing firms. Workers may demand higher wages, fuelled in part either by
a recognition that there is excess demand in the labor market and/or because of expected
higher inflation. As inflation accelerates, workers demand higher wages in the next round
and a wage-price spiral develops.
The Phillips Curve
The Phillips curve suggested that the curve offered policymakers a menu of possible
economic outcomes. By altering monetary and fiscal policy to influence AD, policymakers
could choose any point on this curve. Point A offers high unemployment but low inflation,
and point B offers low unemployment but high inflation. Policymakers might prefer low
unemployment and low inflation but historical data shows that this is impossible, also
summarized by the Phillips Curve.
Aggregate Demand, Aggregate Supply, and the Phillips Curve
The Phillips Curve shows the combinations of inflation and unemployment that arise in the
short run as shifts in the AD curve move the economy along the SRAS. An increase in the
AD for goods and services leads, in the short run, to a larger output of goods and services
and a higher price level. Larger output means a lower rate of unemployment, and if the price
level is higher than the previous year, then there will be a higher rate of inflation. Thus, shifts
in AD push inflation and unemployment in opposite directions in the short run.
Inflation and Unemployment
We discussed the long-run determinants of unemployment and inflation. We saw that the
natural rate of unemployment depends on things in the labor market such as minimum wage
laws, the market power of unions, the role of efficiency wages and the effectiveness of job
search. By contrast, the inflation rate depends primarily on growth in the money supply,
which a nation’s central bank controls. In the long run, therefore inflation and unemployment
are largely unrelated problems. In the short-run, the situation is very different.
The links between the rate of increase in wages and inflation are part of the short-run cause
of inflation referred to as cost-push inflation. Cost-push inflation occurs where firms face
higher costs and pass these on in the form of higher prices. Wages are one of the most
important costs of facing firms. Workers may demand higher wages, fuelled in part either by
a recognition that there is excess demand in the labor market and/or because of expected
higher inflation. As inflation accelerates, workers demand higher wages in the next round
and a wage-price spiral develops.
The Phillips Curve
The Phillips curve suggested that the curve offered policymakers a menu of possible
economic outcomes. By altering monetary and fiscal policy to influence AD, policymakers
could choose any point on this curve. Point A offers high unemployment but low inflation,
and point B offers low unemployment but high inflation. Policymakers might prefer low
unemployment and low inflation but historical data shows that this is impossible, also
summarized by the Phillips Curve.
Aggregate Demand, Aggregate Supply, and the Phillips Curve
The Phillips Curve shows the combinations of inflation and unemployment that arise in the
short run as shifts in the AD curve move the economy along the SRAS. An increase in the
AD for goods and services leads, in the short run, to a larger output of goods and services
and a higher price level. Larger output means a lower rate of unemployment, and if the price
level is higher than the previous year, then there will be a higher rate of inflation. Thus, shifts
in AD push inflation and unemployment in opposite directions in the short run.
