16.3 Inflation and Unemployment in the Long Run

The short-run Phillips curve says that at any given point in time there is a trade-off between unemployment and inflation. According to this view, policy-makers have a choice: they can choose to accept that, in the short run, the price to achieve low unemployment is that the inflation rate must be high. In fact, during the 1960s many economists believed that this trade-off represented a real choice.

However, this view was greatly altered by the later recognition that expected inflation affects the shortrun Phillips curve. In the short run, expectations often diverge from reality. In the long run, however, any consistent rate of inflation will be reflected in expectations. If inflation is consistently high, as it was in the 1970s, people will come to expect more of the same; if inflation is consistently low, as it has been in recent years, that, too, will become part of expectations.

So what does the trade-off between inflation and unemployment look like in the long run, when actual inflation is fully incorporated into expectations? Most macroeconomists believe that there is, in fact, no long-run trade-off. That is, it is not possible to achieve lower unemployment in the long run by accepting higher inflation. To see why, we need to introduce another concept: the long-run Phillips curve.

The Long-Run Phillips Curve

Figure 16-11 reproduces the two short-run Phillips curves from Figure 16-9, SRPC0 and SRPC2. It also adds an additional short-run Phillips curve, SRPC4, representing a 4% expected rate of inflation. In a moment, we’ll explain the significance of the vertical long-run Phillips curve, LRPC.

Figure16-11The NAIRU and the Long-Run Phillips Curve SRPC0 is the short-run Phillips curve when the expected inflation rate is 0%. At a 4% unemployment rate, the economy is at point A with an actual inflation rate of 2%. The higher inflation rate will be incorporated into expectations, and the SRPC will shift upward to SRPC2. If policy-makers act to keep the unemployment rate at 4%, the economy will be at B and the actual inflation rate will rise to 4%. Inflationary expectations will be revised upward again, and SRPC will shift to SRPC4. At a 4% unemployment rate, the economy will be at C and the actual inflation rate will rise to 6%. Here, an unemployment rate (level) of 6% is the NAIRU, or non-accelerating inflation rate of unemployment. As long as unemployment is at the NAIRU, the actual inflation rate will match expectations and remain constant. An unemployment rate below 6% requires ever-accelerating inflation. The long-run Phillips curve, LRPC, which passes through E0, E2, and E4, is vertical: no long-run trade-off between unemployment and inflation exists.

Suppose that the economy has, in the past, had a 0% inflation rate and that this rate is expected to continue into the near future. In that case, the current short-run Phillips curve will be SRPC0, reflecting a 0% expected inflation rate. If the unemployment rate is 6%, the actual inflation rate will be 0%.

Also suppose that policy-makers decide to trade off lower unemployment for a higher rate of inflation. They use monetary policy, fiscal policy, or both to drive the unemployment rate down to 4%. This puts the economy at point A on SRPC0, leading to an actual inflation rate of 2%.

Over time, the public will come to expect a 2% inflation rate. This increase in inflationary expectations will shift the short-run Phillips curve upward to SRPC2. Now, when the unemployment rate is 6%, the actual inflation rate will be 2%. Given this new short-run Phillips curve, policies adopted to keep the unemployment rate at 4% will lead to a 4% actual inflation rate—point B on SRPC2—rather than point A with a 2% actual inflation rate.

Eventually, the 4% actual inflation rate gets built into expectations about the future inflation rate, and the short-run Phillips curve shifts upward yet again to SRPC4. To keep the unemployment rate at 4% would now require accepting a 6% actual inflation rate, point C on SRPC4, and so on. In short, a persistent attempt to trade off lower unemployment for higher inflation leads to accelerating inflation over time.

To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation. This is the situation at E0 on SRPC0: when the expected inflation rate is 0% and the unemployment rate is 6%, the actual inflation rate is 0%. It is also the situation at E2 on SRPC2: when the expected inflation rate is 2% and the unemployment rate is 6%, the actual inflation rate is 2%. And it is the situation at E4 on SRPC4: when the expected inflation rate is 4% and the unemployment rate is 6%, the actual inflation rate is 4%. As we’ll learn in Chapter 18, this relationship between accelerating inflation and the unemployment rate is known as the natural rate hypothesis.

The non-accelerating inflation rate (level) of unemployment, or NAIRU, is the unemployment rate at which inflation does not change over time.

The unemployment rate at which inflation does not change over time—6% in Figure 16-11—is known as the non-accelerating inflation rate (level) of unemployment, or NAIRU for short. Keeping the unemployment rate below the NAIRU leads to ever-accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long-run trade-off between unemployment and inflation.

The long-run Phillips curve shows the relationship between unemployment and inflation after expectations of inflation have had time to fully adjust to experience.

We can now explain the significance of the vertical line LRPC. It is the long-run Phillips curve, the relationship between unemployment and inflation in the long run, after expectations of inflation have had time to fully adjust to experience. It is vertical because any unemployment rate below the NAIRU leads to ever-accelerating inflation. In other words, the long-run Phillips curve shows that there are limits to expansionary policies because an unemployment rate below the NAIRU cannot be maintained in the long run. Moreover, there is a corresponding point we have not yet emphasized: any unemployment rate above the NAIRU leads to decelerating inflation.

The Natural Rate of Unemployment, Revisited

Recall the concept of the natural rate of unemployment, the portion of the unemployment rate unaffected by the swings of the business cycle. Now we have introduced the concept of the NAIRU. How do these two concepts relate to each other?

The answer is that the NAIRU is another name for the natural rate. The level of unemployment the economy “needs” in order to avoid accelerating inflation, or deflation, is equal to the natural rate of unemployment.

In fact, economists estimate the natural rate of unemployment by looking for evidence about the NAIRU from the behaviour of the inflation rate and the unemployment rate over the course of the business cycle. For example, the way major European countries learned, to their dismay, that their natural rates of unemployment were 9% or more was through unpleasant experience. In the late 1980s, and again in the late 1990s, European inflation began to accelerate as European unemployment rates, which had been above 9%, began to fall, approaching 8%.

In Figure 16-4 we cited OECD estimates of the Canadian natural rate of unemployment. The OECD has a model that predicts changes in the inflation rate based on the deviation of the actual unemployment rate from the natural rate. Given data on actual unemployment and inflation, this model can be used to deduce estimates of the natural rate—and that’s where the OECD numbers come from. As of December 2012, the OECD estimate of the Canadian natural rate of unemployment was 6.45%.

The Costs of Disinflation

Through experience, policy-makers have found that bringing inflation down is a much harder task than increasing it. The reason is that once the public has come to expect continuing inflation, bringing inflation down is painful.

A persistent attempt to keep unemployment below the natural rate leads to accelerating inflation that becomes incorporated into expectations. To reduce inflationary expectations, policy-makers need to run the process in reverse, adopting contractionary policies that keep the unemployment rate above the natural rate for an extended period of time. Recall that disinflation is the process of bringing down inflation that has become embedded in expectations.

DISINFLATION AROUND THE WORLD

The great disinflation of the 1980s wasn’t unique to Canada. A number of other advanced countries also experienced high inflation during the 1970s, then brought inflation down during the early 1980s at the cost of a severe recession. This figure shows the annual rate of inflation in Canada, England, Italy, and the United States from 1970 to 2012. All four nations experienced high inflation rates following the two oil shocks of 1973 and 1979, with the Canadian inflation rate being the least severe of the four. All four nations then weathered severe recessions in order to bring inflation down. Since the 1980s, inflation has remained low and stable in all wealthy nations.

Source: OECD.

Disinflation can be very expensive. As the following Economics in Action documents, the Canadian retreat from high inflation at the beginning of the 1980s appears to have cost the equivalent of about 11% of a year’s real GDP, equivalent to a loss of more than $200 billion today. The justification for paying these costs is that they lead to a permanent gain. Although the economy does not recover the short-term production losses caused by disinflation, it no longer suffers from the costs associated with persistently high inflation. In fact, Canada, the United States, Britain, and other wealthy countries that experienced inflation in the 1970s eventually decided that the longer term benefits of bringing inflation down were worth the required suffering—the large reduction in real GDP in the short term.

Some economists argue that the costs of disinflation can be reduced if policy-makers explicitly state their determination to reduce inflation. A clearly announced, credible policy of disinflation, they contend, can reduce expectations of future inflation and so shift the short-run Phillips curve downward. Some economists believe that the clear determination of the Bank of Canada to combat the inflation of the 1970s was credible enough that the costs of disinflation, huge though they were, were lower than they might otherwise have been.1

THE GREAT DISINFLATION OF THE 1980s

As we’ve mentioned several times in this chapter, Canada ended the 1970s with a high rate of inflation, at least by its own peacetime historical standards—12.5% in 1981. Part of this inflation was the result of one-time events, especially a world oil crisis. But expectations of future inflation at 10% or more per year appeared to be firmly embedded in the economy.

In the early 1980s as the economy slowed down, owing to the disinflationary monetary policy in effect at the time, the output gap became negative, which in turn caused the unemployment rate to rise. By the mid-1980s, however, inflation was running at about 4% per year. Panel (a) of Figure 16-12 shows the annual rate of change in the modified consumer price index (CPI), which helps to measure the core inflation rate. This index, which excludes the eight most volatile components of the CPI—categories such as energy and food prices—is widely regarded as a better indicator of underlying inflation trends than the overall CPI. By this measure, inflation fell from about 10% at the end of the 1970s to about 4% by the mid-1980s.

Figure16-12The Great Disinflation
Sources: Statistics Canada; Parliamentary Budget Officer (PBO).

How was this disinflation achieved? At great cost. In 1981, the Bank of Canada imposed strongly contractionary monetary policies, which pushed the economy into its worst recession since the Great Depression. Panel (b) shows the Parliamentary Budget Office estimate of the Canadian output gap from 1980 to 1989 and the unemployment rate from 1979 to 1989: by 1983, actual output was 4.6% below potential output, corresponding to an unemployment rate of 12%. Aggregate output didn’t get back to potential output until 1987. The unemployment rate did not return to its pre-recession rate until 1988.

Our analysis of the long-run Phillips curve tells us that a temporary rise in unemployment, like that of the 1980s, is needed to break the cycle of inflationary expectations. Once expectations of inflation are reduced, the economy can return to the natural rate of unemployment at a lower inflation rate. And that’s just what happened.

But the cost was huge. If you add up the output gap over 1982–1987, you find that the economy sacrificed approximately 11% of an average year’s output over the period. If we had to do the same thing today, that would mean giving up more than $200 billion worth of goods and services.

Quick Review

  • Policies that keep the unemployment rate below the NAIRU, the non-accelerating rate (level) of inflation, will lead to accelerating inflation as inflationary expectations adjust to higher levels of actual inflation. The NAIRU is equal to the natural rate of unemployment.

  • The long-run Phillips curve is vertical and shows that an unemployment rate below the NAIRU cannot be maintained in the long run. As a result, there are limits to expansionary policies.

  • Disinflation imposes high costs—unemployment and lost output—on an economy. Governments do it to avoid the costs of persistently high inflation.

Check Your Understanding 16-3

CHECK YOUR UNDERSTANDING 16-3

Question 16.5

Why is there no long-run trade-off between unemployment and inflation?

There is no long-run trade-off between inflation and unemployment because once expectations of inflation adjust, wages will also adjust, returning employment and the unemployment rate to their equilibrium (natural) levels. This implies that once expectations of inflation fully adjust to any change in actual inflation, the unemployment rate will return to the natural rate of unemployment, or NAIRU. This also implies that the long-run Phillips curve is vertical.

Question 16.6

British economists believe that the natural rate of unemployment in that country rose sharply during the 1970s, from around 3% to as much as 10%. During that period, Britain experienced a sharp acceleration of inflation, which for a time went above 20%. How might these facts be related?

There are two possible explanations for this. First, negative supply shocks (for example, increases in the price of oil) will cause an increase in unemployment and an increase in inflation. Second, it is possible that British policy-makers attempted to peg the unemployment rate below the natural rate of unemployment. Any attempt to peg unemployment below the natural rate will result in an increase in inflation.

Question 16.7

Why is disinflation so costly for an economy? Are there ways to reduce these costs?

Disinflation is costly because to reduce the inflation rate, aggregate output in the short run must typically fall below potential output. This, in turn, results in an increase in the unemployment rate above the natural rate. In general, we would observe a reduction in real GDP. The costs of disinflation can be reduced by not allowing inflation to increase in the first place. Second, the costs of any disinflation will be lower if the central bank is credible and it announces in advance its policy to reduce inflation. In this situation, the adjustment to the disinflationary policy will be more rapid, resulting in a smaller loss of aggregate output.