Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment

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Probably the single most important macroeconomic relationship is the Phillips curve.

—George Akerlof

There is always a temporary tradeoff between inflation and unemployment; there is no permanent tradeoff. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation.

—Milton Friedman

Most economists analyze short-run fluctuations in national income and the price level using the model of aggregate demand and aggregate supply. In the previous three chapters, we examined aggregate demand in some detail. The IS–LM model—together with its open-economy cousin the Mundell–Fleming model—shows how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand curve. In this chapter, we turn our attention to aggregate supply and develop theories that explain the position and slope of the aggregate supply curve.

When we introduced the aggregate supply curve in Chapter 10, we established that aggregate supply behaves differently in the short run than in the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical. When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural level. By contrast, in the short run, prices are sticky, and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand do cause fluctuations in output. In Chapter 10 we took a simplified view of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme situation in which all prices are fixed. Our task now is to refine this understanding of short-run aggregate supply to better reflect the real world in which some prices are sticky and others are not.

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After examining the basic theory of the short-run aggregate supply curve, we establish a key implication. We show that this curve implies a tradeoff between two measures of economic performance—inflation and unemployment. This tradeoff, called the Phillips curve, tells us that to reduce the rate of inflation policymakers must temporarily raise unemployment, and to reduce unemployment they must accept higher inflation. As the quotation from Milton Friedman at the beginning of the chapter suggests, the tradeoff between inflation and unemployment is only temporary. One goal of this chapter is to explain why policymakers face such a tradeoff in the short run and, just as important, why they do not face it in the long run.