Chapter 12: Unemployment and Inflation

Relevant Textbook Solutions (some have been omitted)

Review Questions

1. The Phillips curve is an empirical negative relationship between inflation and unemployment.
The Phillips curve relationship held for U.S. data in the 1960s, but broke down in the 1970s and
1980s.

2. In the traditional Phillips curve, inflation itself is related to the unemployment rate. In the
expectations-augmented Phillips curve, it is unanticipated inflation (the difference between
actual and expected inflation) that is related to cyclical unemployment (the difference between
the unemployment rate and the natural rate of unemployment).

The traditional Phillips curve appears in the data at times when both expected inflation and the
natural rate of unemployment are fixed.

3. In the early 1960s the rate of inflation was fairly low (about 1% to 2%), and it didn’t vary
much from year to year. But supply shocks hit the economy in both the mid- and the late-1970s,
causing a rise in expected inflation and an upward shift in the Phillips curve. Expansionary
monetary and fiscal policies kept inflation high in the 1970s until the Federal Reserve began
pursuing contractionary monetary policy to reduce inflation during 1979–1982. This moved the
economy to a lower Phillips curve, which was maintained in the 1980s. The instability of the
Phillips curve is largely because of higher expected inflation associated with supply shocks in the
1970s.

4. According to the classical point of view, the economy adjusts quickly to changes in inflation,
so there is only a very short period in which unemployment changes because of a change in
inflation. Further, any systematic attempt to reduce unemployment by increasing inflation would
be fully anticipated, and would have no effect on unemployment.

Keynesians believe, however, that there is a temporary trade-off between unemployment and
inflation. If policymakers want to, they can increase inflation to reduce unemployment in the
short run. However, the economy must return to the natural rate of unemployment in the long
run, so the reduction in unemployment is only temporary.

5. Policymakers want to keep inflation low because inflation imposes costs on the economy.
Costs of anticipated inflation include shoe leather costs and menu costs. Costs of unanticipated
inflation include unpredictable transfers of wealth between lenders and borrowers, resources
used to reduce the risk of such transfers, and reduced efficiency because of the difficulty in
observing relative prices.

When there is cyclical unemployment, society as a whole loses because of output that is not
produced and the families of the unemployed suffer personal and psychological costs.

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6. The natural rate of unemployment is the rate of unemployment that exists when output is at its
full-employment level. This occurs when the only unemployment is frictional and structural, not
cyclical. The natural rate is crucial in understanding the Phillips curve.

The natural rate of unemployment has moved higher over time in the United States and Europe
due to a number of factors. First, demographic changes occurred that raised the natural rate.
Groups in the labor force that have higher rates of unemployment have increased in size relative
to groups that have lower rates of unemployment. Also, there have been structural changes in the
economy that may have raised the natural rate in the 1970s. In Europe, hysteresis has kept the
unemployment rate from declining much after it hit very high levels in the early 1980s.
Hysteresis arises because of government regulation and bureaucratic aspects of firms and labor
unions, and due to insiders keeping outsiders from gaining employment.

To reduce the natural rate of unemployment, the government could support job training and
worker relocation, reduce regulations to increase labor market flexibility, reform unemployment
insurance, or create a high-pressure economy.

7. Two costs of anticipated inflation are shoe-leather costs and menu costs. Two costs of
unanticipated inflation are transfers of wealth and confusion of price signals.

If the economy experiences hyperinflation, shoe-leather costs become very large as people try to
minimize their cash holdings. Also, prices change so frequently they cease to serve as signals.
Menu costs do not rise too much, as firms simply quote prices in terms of some other unit of
account (a different country’s currency). Transfers of wealth also occur, especially since the
government loses tax revenue as people delay paying taxes.

8. The greatest potential cost of disinflation is that it may cause a recession. This occurs because
inflation may fall below expected inflation, causing the unemployment rate to rise along
the Phillips curve.

However, if the public anticipates the disinflation, expected inflation will adjust quickly and the
costs of disinflation will be low.

9. One approach to disinflation is a cold turkey strategy. It has the advantage of reducing
inflation quickly, but it may have high costs from increasing unemployment, according to
Keynesians.

So Keynesians suggest a gradualist policy to reduce inflation more slowly, but with less rise in
unemployment. This also has the advantage of being politically sustainable, since policymakers
are less likely to back off from disinflation.

10. The Federal Reserve works hard to establish its credibility so that the costs of reducing
inflation will be low. If the Federal Reserve has a great deal of credibility, then people will
believe that the inflation rate will not rise in the future, so the expected inflation rate will be low
and stable. The sacrifice ratio will also be low, so the costs of disinflation will be reduced.

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Numerical Problems

1. Since the natural rate of unemployment is 0.06, π = π e

− 2 (u − 0.06), so u − 0.06 = 0.5 (π e

− π ), or u = 0.06 + 0.5 (π e − π ).

(a) Year 1: u = 0.06 + 0.5 (0.08 − 0.04) = 0.06 + 0.02 = 0.08. The unemployment rate is 0.02
higher than the natural rate. The percentage that output falls short of full-employment output is
2 ∗ 0.02 = 0.04, or 4%.

Year 2: u = 0.06 + 0.5 (0.04 − 0.04) = 0.06. The unemployment rate equals the natural rate,
since inflation equals expected inflation. Since unemployment is at its natural rate, output is at its
full-employment level.

Since the output loss was 4 percentage points and inflation declined by 8 percentage points, the
sacrifice ratio is 4/8 = 0.5.

(b) Use equations: u = 0.06 + 0.5 (π e

– π ), output shortfall = 2 (u – 0.06).

Year π π e
u u − 0.06 Output
Shortfall
1 0.08 0.10 0.07 0.01 0.02
2 0.04 0.08 0.08 0.02 0.04
3 0.04 0.06 0.07 0.01 0.02
4 0.04 0.04 0.06 0.0 0.0

The total output shortfall is 0.02 + 0.04 + 0.02 + 0.0 = 0.08 = 8-percentage points of output lost.
Inflation fell by 8 percentage points. So the sacrifice ratio is 8/8 = 1. Notice that, compared with
part a, the sacrifice ratio is higher, for this slower disinflation.

2.
(a) Equating aggregate demand to short-run aggregate supply gives: 300 + 10 (M/P) = 500 + P −
Pe, or 300 + (10 ∗ 1000/P) = 500 + P − 50, or 10,000/P = 150 + P. Multiplying both sides of the
equation by P and rearranging gives P2 + 150P − 10,000 = 0, which can be factored as (P − 50)
(P + 200) = 0. This has the nonnegative solution P = 50. Since Pe is also 50, the expected price
level equals the actual price level, so output is at its full-employment level of 500 and the
unemployment rate is at the natural rate of 6%. These are the long-run equilibrium values of
the three variables as well.

(b) When the nominal money supply increases unexpectedly to 1260, we again equate aggregate
demand to short-run aggregate supply, which gives: 300 + 10 (M/P) = 500 + P − Pe, or 300 +
(10 ∗ 1260/P) = 500 + P − 50, or 12,600/P = 150 + P. Multiplying both sides of the equation by
P and rearranging gives P2 + 150P − 12,600 = 0, which can be factored as (P − 60)(P + 210) = 0.
This has the nonnegative solution P = 60. When P = 60, the short-run aggregate supply curve
gives Y = 500 + P − Pe = 500 + 60 − 50 = 510. Output of 510 is 2% above full-employment

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output of 500, because (510 − 500)/500 = 0.02. With a natural unemployment rate of 0.06,
Okun’s Law gives 0.02 = − 2 (u − 0.06). This can be solved to get u = 0.05.

In the long run, Pe adjusts to equal P, output adjusts to its full-employment level of 500, and
unemployment adjusts to the natural rate of 0.06. To find P, use the aggregate demand curve
to get 500 = 300 + 10 (1260/P), or 200 = 12,600/P, which can be solved to get P = 63.

The results of this exercise are consistent with the existence of an expectations-augmented
Phillips curve. Unexpected inflation reduces unemployment in the short run. In the long run,
however, inflation is higher and unemployment returns to its natural rate.

3.
(a) π = 0.10 − 2 (u − 0.06) = 0.22 − 2u. This is shown as the Phillips curve labeled PCa in Figure
12.6. If the Fed keeps inflation at 0.10, then u = 0.06, the natural rate of unemployment.

Figure 12.6

(b) With expected inflation rising to 12%, the Phillips curve is π = 0.12 – 2 (u – 0.06) = 0.24 –
2u. This is the Phillips curve labeled PC b in the figure. The higher rate of expected inflation has
caused the curve to shift up relative to where it was in part (a). With the actual inflation rate at
10%, the Phillips curve equation is 0.10 = 0.12 – 2 (u – 0.06), which has the solution u = 0.07.
So if the Fed tries to maintain the existing rate of inflation after a shock has raised inflation
expectations, the unemployment rate increases. However, if the Fed could convince people that
the inflation rate really would not rise, so that π e remains at 0.10, then the short-run Phillips
curve would remain at PC a, and the unemployment rate would not increase.

(c) With the natural rate of unemployment rising to 0.08 at the same time that expected inflation
rises to 0.12, the Phillips curve equation is π = 0.12 − 2 (u − 0.08) = 0.28 − 2u. This is the
Phillips curve labeled PC c in the figure. The new short-run Phillips curve is even higher than
those for parts (a) and (b). With the actual inflation rate held to 10%, the equation becomes 0.10 =

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0.28 − 2u, which can be solved to get u = 0.09. The unemployment rate rises both because the
Fed holds inflation below expected inflation and because the natural rate has increased.

This time, even if the Fed convinced people that inflation would remain just 10%, the
unemployment rate would still rise to 8%, since the natural rate has increased to that level.

4.
(a) Beginning in long-run equilibrium, with M = 4000, output must be at its full-employment
level of 6000 and the unemployment rate must be equal to the natural rate of .05. Using the
values for Y and M in the AD curve, 6000 = 4000 + 2 (4000/P), which gives P = 4. This is also
the expected price level. Because M has been constant for a long time and is expected to remain
constant, π e = 0.

(b) With P e = 4, the SRAS curve is Y = 6000 + 100 (P − 4). The AD curve is Y = 4000 + 2
(4488/P). The intersection of the two curves occurs when 6000 + 100 (P − 4) = 4000 + 2
(4488/P). Simplifying terms gives 100P2 + 1600P − 8976 = 0, which has the solution P = 4.4.
Plugging this into the SRAS curve gives Y = 6040.

From the Okun’s Law equation we get (6040 − 6000)/6000 = −2 (u − 0.05), so – 0.00333 = u −
0.05, so u = .0467. Cyclical unemployment is u − u = − 0.0033. Unanticipated inflation is (P −
Pe)/Pe = 0.10 = 10%.

(c) The Phillips curve equation is π = π e − h (u − u ), which gives .10 = 0 − h (.0467 − 0.05).
This is solved to get h = 30. So the slope of the Phillips curve is −30.

Analytical Problems

1.
(a) The reduction in structural unemployment would reduce the natural rate of unemployment
and thus would shift both the expectations-augmented Phillips curve and the long-run Phillips
curve to the left.

(b) Despite the expense of the government program to reduce structural unemployment, it would
have a permanent effect. Monetary expansion can work only temporarily—in the long run it
has no effect.

2. Omitted

3. Omitted

4. In the cashless society, there would be no shoe-leather costs, as there would be no cash
balances on which to economize. But menu costs would remain for anticipated inflation. The
costs of unanticipated inflation would remain as well: both the risk of wealth transfers plus
confusion in price signals.

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5.
(a) Figure 12.9 shows the effects of increasing the money supply while holding the price level
constant. Beginning at point A, the intersection of aggregate demand curve AD1 and short-run
aggregate supply curve SRAS1, the increase in the money supply shifts the aggregate demand
curve to AD2. Since prices cannot rise, the short-run equilibrium is at point B, with output above
its full-employment level.

Figure 12.9

(b) When the price controls are removed, the price level will jump up, with the short-run
aggregate supply curve shifting to SRAS2. The new equilibrium is at point C, where there is full
employment.

6.
(a) A new law that prohibits people from seeking employment before age eighteen is likely to
reduce the natural rate of unemployment because teenagers have a higher-than-average
unemployment rate. With no teenagers allowed in the labor force, the average unemployment rate
would be lower.

(b) A service that makes looking for a job easier is able to match people and jobs more rapidly,
which should reduce the natural rate of unemployment.

(c) If unemployed workers can receive benefits longer, they’ll be in less of a rush to take a job,
so the job-matching process will take longer. As a result, the natural rate of unemployment will
rise.

(d) A structural shift in the types of products people buy is likely to raise the natural rate of
unemployment, because it will take time for the economy to shift workers from some types
of occupations to others.

(e) A recession leads to a rise in cyclical unemployment, but doesn’t affect the natural rate of
unemployment.