Mankiw. Principles Of Economics (2003)

(a) The Model of Aggregate Demand and Aggregate Supply

(b) The Phillips Curve

Phillips curve

IN THE NEWS

The Effects of

Low Unemployment

and other users. “Three years ago he’d have probably stuck it out.”

This is just one of the many examples of how a growing number of companies these days are facing something they have not seen for many years: a tight labor market in which many workers can be much more choosy about their job. Breaking a sweat can be reason enough to quit in search of better opportunities.

“This summer’s been extremely difficult, with unemployment so low,” said Eleanor J. Brown, proprietor of a small temporary-help agency in nearby Culpeper, which supplies workers to

incomes, financial markets, and political campaigns as well as business profitability itself.

So far, the tightening labor market has generated only scattered—and in most cases modest—pay increases. Most companies, unable to pass on higher costs by raising prices because of intense competition from foreign and domestic rivals, are working even harder to keep a lid on labor costs, in part by adopting novel ways of coupling pay to profits.

“The overriding need is for expense control,” said Kenneth T. Mayland, chief

financial economist at Keycorp, a Cleveland bank, “at a time when revenue growth is constrained.”

But with unemployment already at a low 5.5 percent and the economy looking stronger than expected this summer, more analysts are worried that it may be only a matter of time before wage pressures begin to build again as they did in the late 1980s. . . .

The labor shortages are widespread and include both skilled and unskilled jobs. Among the hardest occupations to fill are computer analyst and programmer, aerospace engineer, construction trades worker, and various types of salespeople. But even fast food establishments in the St. Louis area and elsewhere have resorted to signing bonuses as well as premium pay and more generous benefits to attract applicants. . . .

So far, upward pressure on pay is relatively modest, a phenomenon that economists say is surprising in light of an

uninterrupted business expansion that is now five and a half years old.

“We have less wage pressure than, historically, anyone would have guessed,” said Stuart G. Hoffman, chief economist at PNC Bank in Pittsburgh.

But wages have already crept up a bit and could accelerate even if the economy slackens from its recent rapid growth pace. And if the economy maintains significant momentum, some analysts say, all bets are off. If growth continues another six months at above 2.5 percent or so, Mark Zandi, chief economist for Regional Financial Associates, said, “we’ll be looking at wage inflation right square in the eye.” . . .

[ Author’s note: In fact, wage inflation did rise. The rate of increase in compensation per hour paid by U.S. businesses rose from 1.8 percent in 1994 to 4.4 percent in 1998. But thanks to a fall in world commodity prices and a surge in productivity growth, higher wage inflation didn’t translate into higher price inflation. A case

study later in this chapter considers these events in more detail.]

One worker who has taken advantage of the current environment is Clyde Long, a thirty-year-old who switched jobs to join Trinity Packaging in May. He had been working about two miles away at Ross Industries, which makes foodprocessing equipment, and quit without having anything else lined up.

In a week, Mr. Long had hired on at Trinity where, as a press operator, he now earns $8.55 an hour—$1.25 more than at his old job—with better benefits and training as well. “It’s a whole lot better here,” he said.

SOURCE: The New York Times, September 5, 1996, p. D1.

Figur e 21-3

THE LONG-RUN PHILLIPS CURVE.

According to Friedman and Phelps, there is no tradeoff between inflation and unemployment in the long run. Growth in the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical.

Price

Level

P2

2. . . . raises the price

level . . . P1

0

Long-run aggregate supply

1. An increase in the money supply

increases aggregate

B

demand . . .

A

AD2

Aggregate demand, AD1

This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation. In the short run, expected inflation is given. As a result, higher actual inflation is associated with lower unemployment. (How much unemployment responds to unexpected inflation is determined by the size of a, a number that in turn depends on the slope of the short-run aggregatesupply curve.) In the long run, however, people come to expect whatever inflation the Fed produces. Thus, actual inflation equals expected inflation, and unemployment is at its natural rate.

This equation implies there is no stable short-run Phillips curve. Each shortrun Phillips curve reflects a particular expected rate of inflation. (To be precise, if you graph the equation, you’ll find that the short-run Phillips curve intersects the long-run Phillips curve at the expected rate of inflation.) Whenever expected inflation changes, the short-run Phillips curve shifts.

According to Friedman and Phelps, it is dangerous to view the Phillips curve as a menu of options available to policymakers. To see why, imagine an economy at its natural rate of unemployment with low inflation and low expected inflation, shown in Figure 21-5 as point A. Now suppose that policymakers try to take advantage of the tradeoff between inflation and unemployment by using monetary or fiscal policy to expand aggregate demand. In the short run when expected inflation is given, the economy goes from point A to point B. Unemployment falls below its natural rate, and inflation rises above expected inflation. Over time, people get used to this higher inflation rate, and they raise their expectations of inflation. When expected inflation rises, firms and workers start taking higher inflation into

HOW EXPECTED INFLATION

SHIFTS THE SHORT-RUN

PHILLIPS CURVE. The higher the expected rate of inflation, the higher the short-run tradeoff between inflation and unemployment. At point A, expected inflation and actual inflation are both low, and unemployment is at its natural rate. If the Fed pursues an expansionary monetary policy, the economy moves from point A to point B in the short run. At point B, expected inflation is still low, but actual inflation is high. Unemployment is below its natural rate. In the long run, expected inflation rises, and the economy moves to point C. At point C, expected inflation and actual inflation are both high, and unemployment is back

to its natural rate.

natural-rate hypothesis the claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation

account when setting wages and prices. The short-run Phillips curve then shifts to the right, as shown in the figure. The economy ends up at point C, with higher inflation than at point A but with the same level of unemployment.

Thus, Friedman and Phelps concluded that policymakers do face a tradeoff between inflation and unemployment, but only a temporary one. If policymakers use this tradeoff, they lose it.

THE NATURAL EXPERIMENT

FOR THE NATURAL-RATE HYPOTHESIS

Friedman and Phelps had made a bold prediction in 1968: If policymakers try to take advantage of the Phillips curve by choosing higher inflation in order to reduce unemployment, they will succeed at reducing unemployment only temporarily. This view—that unemployment eventually returns to its natural rate, regardless of the rate of inflation—is called the natural-rate hypothesis. A few years after Friedman and Phelps proposed this hypothesis, monetary and fiscal policymakers inadvertently created a natural experiment to test it. Their laboratory was the U.S. economy.

Before we see the outcome of this test, however, let’s look at the data that Friedman and Phelps had when they made their prediction in 1968. Figure 21-6 shows the unemployment rate and the inflation rate for the period from 1961 to 1968. These data trace out a Phillips curve. As inflation rose over these eight years, unemployment fell. The economic data from this era seemed to confirm the tradeoff between inflation and unemployment.

The apparent success of the Phillips curve in the 1960s made the prediction of Friedman and Phelps all the more bold. In 1958 Phillips had suggested a negative

Figur e 21-6

THE PHILLIPS CURVE

IN THE 1960S. This figure uses annual data from 1961 to 1968 on the unemployment rate and on the inflation rate (as measured by the GDP deflator) to show the negative relationship between inflation and unemployment.

SOURCE: U.S. Department of Labor;

U.S. Department of Commerce.

Inflation Rate (percent per year)

Rate (percent)

Inflation Rate (percent per year)

Rate (percent)

Figur e 21-7

THE BREAKDOWN OF

THE PHILLIPS CURVE. This

figure shows annual data from 1961 to 1973 on the unemployment rate and on the inflation rate (as measured by

the GDP deflator). Notice that the Phillips curve of the 1960s breaks down in the early 1970s.

SOURCE: U.S. Department of Labor;

U.S. Department of Commerce.