CHAPTER

35
The Short-Run Trade-off
between Inflation and
Unemployment
Goals
In this chapter you will

Learn why policymakers face a short-run trade-off between

inflation and unemployment
Consider why the inflation-unemployment trade-off disappears in
the long run
See how supply shocks can shift the inflation-unemployment
trade-off
Consider the short-run cost of reducing the rate of inflation
See how policymakers credibility affects the cost of reducing
inflation

Outcomes

Draw a graph of a short-run Phillips curve

After accomplishing
these goals, you
should be able to

Draw a graph of a long-run Phillips curve

Show the relationship between a shift in the short-run aggregatesupply curve and a shift in the short-run Phillips curve

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CHAPTER 35

THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

Strive for a Five

Content from Chapter 35 will be tested on the AP macroeconomics exam. Recently, it has
been tested in the free response portion as well as the multiple-choice section.You should
be prepared to create and explain a model of the Phillips curve with the long-run Phillips
curve displayed.
The Phillips curve
Long-run Phillips curve
Changes in the Philips curve as it pertains to aggregate supply and aggregate demand
Explain the sacrifice ratio
Explain why more than rational expectations are needed to reduce inflation without
cost

Key Terms

Misery indexThe sum of inflation and unemployment

Phillips curveThe short-run trade-off between inflation and unemployment
Natural rate of unemploymentThe normal rate of unemployment toward which the
economy gravitates
Natural-rate hypothesisThe theory that unemployment returns to its natural rate,
regardless of inflation
DisinflationA reduction in the rate of inflation
Supply shockAn event that directly alters firms costs and prices, shifting the
economys aggregate-supply curve and, thus, the Phillips curve
Sacrifice ratioThe number of percentage points of annual output that is lost in order
to reduce inflation one percentage point
Rational expectationsThe theory that suggests that people optimally use all available
information, including about government policies, when forecasting the future

Chapter Overview
Context and Purpose
Chapter 35 is the final chapter in a three-chapter sequence on the economys short-run
fluctuations around its long-term trend. Chapter 33 introduced aggregate supply and
aggregate demand. Chapter 34 developed how monetary and fiscal policy affect aggregate
demand. Both Chapters 33 and 34 addressed the relationship between the price level
and output. Chapter 35 will concentrate on a similar relationship between inflation and
unemployment.
The purpose of Chapter 35 is to trace the history of economists thinking about the
relationship between inflation and unemployment.You will see why there is a temporary
trade-off between inflation and unemployment and why there is no permanent trade-off.
This result is an extension of the results produced by the model of aggregate supply and
aggregate demand where a change in the price level induced by a change in aggregate
demand temporarily alters output but has no permanent impact on output.

Chapter Review
Introduction Since both inflation and unemployment are undesirable, the sum of inflation
and unemployment has been termed the misery index. Inflation and unemployment are
independent in the long run because unemployment is determined by features of the
labor market while inflation is determined by money growth. However, in the short
run, inflation and unemployment are related because an increase in aggregate demand

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THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

temporarily increases inflation and output while it lowers unemployment. In this chapter,
we trace the history of our understanding of the relationship between unemployment and
inflation.

The Phillips Curve

In 1958, a British economist named A. W. Phillips found a negative relationship between
inflation and unemployment. That is, years of high inflation are associated with low
unemployment. This negative relationship has been found for other countries, including
the United States, and has been termed the Phillips curve. The Phillips curve appears to
offer policymakers a menu of inflation and unemployment choices. To have lower unemployment, one need only choose a higher rate of inflation.
The model of aggregate supply and aggregate demand can explain the relationship
described by the Phillips curve. The Phillips curve shows the combinations of inflation and
unemployment that arise in the short run as shifts in the aggregate-demand curve move
along a short-run aggregate-supply curve. For example, an increase in aggregate demand
moves the economy along a short-run aggregate-supply curve to a higher price level, a
higher level of output, and a lower level of unemployment. Since prices in the previous
period are now fixed, a higher price level in the current period implies a higher rate of
inflation, which is now associated with a lower rate of unemployment. This can be seen in
Exhibit 1. An increase in aggregate demand, which moves the economy from point A to
point B in panel (a), is associated with a movement along the short-run Phillips curve from
point A to point B.
Shifts in the Phillips Curve: The Role of Expectations
In 1968, U.S. economists Friedman and Phelps argued that the Phillips curve is not a
menu policymakers can exploit. This is because, in the long run, money is neutral and has
no real effects. Money growth just causes proportional changes in prices and incomes and
should have no impact on unemployment. Therefore, the long-run Phillips curve should
be vertical at the natural rate of unemploymentthe rate of unemployment to which the
economy naturally gravitates.
A vertical long-run Phillips curve corresponds to a vertical long-run aggregate-supply
curve. As Exhibit 1 illustrates, in the long run, an increase in the money supply shifts
aggregate demand to the right and moves the economy from point A to point C in panel
(a). The corresponding Phillips curve is found in panel (b) where an increase in money

1
Long-run
Phillips Curve

Long-run
Aggregate Supply
Short-run
Aggregate
Supply
C

Inflation Rate

Price Level

EXHIBIT

C
B

B
A

AD2

Short-run
Phillips Curve

AD1
Natural
Rate of
Output
Panel (a)

Quantity
of Output

Natural Unemployment
Rate
Rate of
Unemployment
Panel (b)

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growth increases inflation, but because money is neutral in the long run, prices and
incomes move together and inflation fails to affect unemployment. Thus, the economy
moves from point A to point C in panel (b) and traces out the long-run Phillips curve.
Friedman and Phelps used the phrase natural rate of unemployment, not because
it is either desirable or constant, but because it is beyond the influence of monetary
policy. Changes in labor market policies such as changes in minimum-wage laws and
unemployment insurance that lower the natural rate of unemployment shift the long-run
Phillips curve to the left and the long-run aggregate-supply curve to the right.
Even though Friedman and Phelps argued that the long-run Phillips curve is
vertical, they argued that, in the short run, inflation could have a substantial impact on
unemployment. Their reasoning is similar to that surrounding the short-run aggregatesupply curve in that they assume, in the short run, price expectations are fixed. If price
expectations are fixed in the short run, an increase in aggregate demand causes inflation,
temporarily increases output, and lowers unemployment below the natural rate. For
example, according to the sticky-wage theory of short-run aggregate supply, nominal
wages are set based on fixed price expectations. When actual prices exceed expected prices,
firms are more profitable, they expand output and employment, and unemployment is
reduced. In Exhibit 2, this is a movement from point A to point B. However, in the long run,
people adjust to the higher rate of inflation by raising their expectations of inflation (and demanding
higher wages) and the short-run Phillips curve shifts upward. The economy moves from point B
to point C with higher inflation but no change in unemployment. Thus, policymakers face
a short-run trade-off between inflation and unemployment, but if they attempt to exploit
it, the relationship disappears and they arrive back on the vertical long-run Phillips curve
at the natural rate of unemployment but at a higher rate of inflation.
The analysis of Friedman and Phelps can be summarized by the following equation:
Unemployment
Rate

Natural Rate of
Unemployment

Actual
Expected

Inflation
Inflation

This says that for any given expected inflation rate, if actual inflation exceeds expected
inflation, unemployment will fall below the natural rate by an amount that depends on the
parameter a. However, in the long run, people learn to expect the inflation that actually
exists, and the unemployment rate will equal the natural rate.
Friedman and Phelps proposed the natural-rate hypothesis, which states that
unemployment eventually returns to its natural rate, regardless of inflation. While
controversial, it proved to be true. During the 1960s, expansionary monetary and fiscal

EXHIBIT
Inflation Rate

358

2
Long-run
Phillips Curve

C
A
Short-run Phillips Curve with
high expected inflation
Short-run Phillips Curve with
low expected inflation

Natural Rate of Unemployment

Rate
Unemployment

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THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

policies steadily increased the rate of inflation and unemployment fell. However, in the
early 1970s, people raised their expectations of inflation and the unemployment rate
returned to the natural rateabout 5 or 6 percent.

Shifts in the Phillips Curve: The Role of Supply Shocks

The short-run Phillips curve can also shift due to a supply shock. A supply shock is an
event that directly alters firms costs and prices, shifting the economys aggregate-supply
curve and Phillips curve. A supply shock occurred in 1974 when OPEC raised oil prices.
This act raised the cost of production and shifted the U.S. short-run aggregate-supply
curve to the left, causing prices to rise and output to fall, or stagflation. Since inflation has
increased and unemployment has increased, this corresponds to a rightward (upward) shift
in the short-run Phillips curve. Policymakers now face a less favorable trade-off between
inflation and unemployment. That is, policymakers must accept a higher inflation rate
for each unemployment rate, or a higher unemployment rate for each inflation rate. Also,
policymakers now have a difficult choice because if they reduce aggregate demand to fight
inflation, they will further increase unemployment. If they increase aggregate demand to
reduce unemployment, they further increase inflation.
If the supply shock raises expected inflation, the Phillips-curve shift is permanent.
If it does not raise expected inflation, the shift is temporary. In the United States during
the 1970s, the Fed accommodated two adverse aggregate supply shocks by increasing
aggregate demand to keep output from falling. This caused expected inflation to rise, and
the rightward (upward) shift in the Phillips curve was permanent. By 1980, inflation was
9 percent and unemployment was 7 percent.
Some argue that in 2008 the Fed is not exerting its independence and is instead
repeating the mistakes of the 1970s by accommodating a negative supply shock.
The Cost of Reducing Inflation
In October 1979, Fed Chairman Paul Volcker chose to pursue a policy of disinflationa
reduction in the rate of inflation. A reduction in the money supply reduces aggregate
demand, reduces production, and increases unemployment. This is shown in Exhibit 3 as a
movement from point A to point B. Over time, expected inflation falls and the short-run
Phillips curve shifts downward and the economy moves from point B to point C.
The cost of reducing inflation is a period of unemployment and lost output. The
sacrifice ratio is the number of percentage points of annual output that is lost to reduce

3
Long-run
Phillips Curve

Inflation Rate

EXHIBIT

A
C

Short-run Phillips Curve with

high expected inflation
Short-run Phillips Curve with
low expected inflation

Natural Rate of Unemployment

Rate
Unemployment

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inflation one percentage point. The amount of output lost depends on the slope of the
Phillips curve and how fast people lower their expectations of inflation.
Some economists estimated the sacrifice ratio to be about five, which is very large.
Supporters of a theory called rational expectations suggested that the cost of disinflation
could be much smaller and may be zero. Rational expectations suggest that people
optimally use all available information, including information about government policies,
when forecasting the future. Thus, an announced policy of disinflation that is credible could
move the economy from point A to point C without traveling through point B.Volcker
announced a disinflationary policy in late 1979 and reduced inflation from 10 percent to 4
percent by 1984 but at the cost of a substantial increase in unemployment. Note, however,
that the increase in unemployment was less than that predicted by the estimated sacrifice
ratio. The rational expectations theory may not be accurate, or people may not have
believed the policy announcement.
Monetary policy under Alan Greenspan did not repeat the mistakes of the 1960s
when excessive aggregate demand pushed unemployment below the natural rate. The low
inflation and low unemployment of the Greenspan era were the result of a favorable supply
shock and prudent monetary policy.
Bernanke faces the following economic challenges: A housing market bust and financial
crisis that reduced aggregate demand, and rising oil and commodity prices that reduced
aggregate supply. Thus, the economy faces rising unemployment and rising inflation.
Bernanke hopes to keep inflation expectations low so that workers wont increase wage
demands and firms wont increase prices.

Helpful Hints
1. Short-run and long-run Phillips curves are almost a mirror image of short-run and
long-run aggregate-supply curves. Look at the supply curves that appear in Exhibit 1.
Notice the aggregate-supply curves in panel (a). Compare them to the Phillips curves
in panel (b). They appear to be mirror images of each other. The long-run aggregatesupply curve is vertical because, in the long run, an increase in the price level is met
by a proportionate increase in all prices and incomes so there is no incentive to alter
production. Since an increase in prices has no effect on output in the long run, it has
no effect on unemployment, and the long-run Phillips curve is vertical in panel (b).
In the short run with price expectations fixed, an increase in the price level provides
an incentive for firms to increase production, causing the short-run aggregate-supply
curve to be positively sloped in panel (a). When output rises, unemployment tends
to fall, so the short-run Phillips curve is negatively sloped in panel (b). In summary,
since both graphs employ some measure of prices on the vertical axis, and since
each graph uses real measures of economic activity that are negatively correlated on
their respective horizontal axes (an increase in output is associated with a decrease in
unemployment), then aggregate-supply curves and Phillips curves should mirror
each other.
2. To understand the short-run Phillips curve, review short-run aggregate supply. To
gain confidence deriving and shifting short-run Phillips curves, review the sources
to the positive slope of the short-run aggregate-supply curve in Chapter 33. There
you will be reminded that there are a number of reasons why a short-run aggregatesupply curve slopes positivelymisperceptions about relative price, sticky wages, and
sticky prices. Since short-run aggregate-supply curves and Phillips curves are mirror

CHAPTER 35

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images of each other, the very same reasons that produce a positive slope in aggregate
supply produce a negative slope in the Phillips curve. Also, recall that all three theories
of the short-run aggregate-supply curve are based on the assumption of fixed price
expectations. When price expectations rise, the short-run aggregate-supply curve shifts
left. Correspondingly, since the short-run aggregate-supply curve and the Phillips
curve are mirror images, a rise in price expectations shifts the Phillips curve to the
right.
3. The Phillips curve establishes a relationship between inflation and unemployment, but
it does not establish causation. Reading the Phillips curve from the unemployment
axis to the inflation axis suggests that when unemployment is unusually low, the labor
market is tight and wages and prices start to rise more quickly.
4. Estimates of the natural rate of unemployment vary widely, causing policymakers to
disagree on the appropriate monetary and fiscal policies. When looking at a Phillips
curve graph or the model of aggregate supply and aggregate demand, it appears as if
policymakers should always know whether to expand or contract aggregate demand
or whether to leave aggregate demand alone. This is because we can see whether
the economy is operating above or below the long-run natural rate that we have
chosen on the graph. In reality, however, the natural rate is very difficult to measure
and policymakers are uncertain whether the economy is actually operating above
or below the natural rate. For example, if the economy is currently operating at 6
percent unemployment, the economy is operating below capacity if the natural rate
of unemployment is 5 percent, at capacity if the natural rate is 6 percent, and above
capacity if the natural rate is 7 percent. Each situation might suggest a different
stabilization policy, even though the actual rate of unemployment is unchanged at 6
percent.

Self-Test
Multiple-Choice Questions
1. In the short run
a. unemployment and inflation are positively related. In the long run, they are
largely unrelated problems.
b. and in the long run, inflation and unemployment are positively related.
c. unemployment and inflation are negatively related. In the long run, they are
largely unrelated problems.
d. and in the long run, inflation and unemployment are negatively related.
e. unemployment and inflation are negatively related. In the long run, they are
largely positively related.

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THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

Figure 35-1
The left-hand graph shows a short-run aggregate-supply (SRAS) curve and two aggregatedemand (AD) curves. On the right-hand diagram, U represents the unemployment rate.
P

362

Phillips Curve

SRAS

130
115

30

B
G

15

D
High AD
Low AD

6%

10%

2. Refer to Figure 35-1. If the economy starts at B, then in the short run, a decrease in
consumer confidence that decreases spending moves the economy to
a. D and G.
b. C and G.
c. A and G.
d. D and F.
e. C and F.
3. Refer to Figure 35-1. Starting at point C, which combination of points would be
correct for an economy that experienced a decrease in unemployment and a price
level increase?
a. D and G
b. D and F
c. A and F
d. A and G
e. B and F
4. In 2001, Congress and President Bush instituted tax cuts. According to the short-run
Phillips curve, in the short run this change should have
a. reduced inflation and unemployment.
b. raised inflation and unemployment.
c. reduced inflation and raised unemployment.
d. raised inflation and reduced unemployment.
e. reduced unemployment and left unemployment unchanged.
5. The current view of the Phillips curve relationship is that
a. the trade-off between inflation and unemployment does not apply in the long run.
b. the trade-off between inflation and unemployment does not apply in the short run.
c. the trade-off between inflation and unemployment does not apply in either the
short run or the long run.
d. the trade-off between inflation and unemployment applies both in the short run
and the long run.
e. the trade-off between inflation and unemployment applies only in the long run
as in the short run there is no trade-off.
6. How would a decrease in the natural rate of unemployment affect the long-run
Phillips curve?
a. It would shift the long-run Phillips curve right.
b. It would shift the long-run Phillips curve left.
c. There would be an upward movement along a given long-run Phillips curve.
d. There would be a downward movement along a given long-run Philips curve.
e. There would be no effect on the long-run Phillips curve.

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THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

Inflation
Rate

Figure 35-2
10
9
8
7
6
5
4
3
2
1

1 2 3 4 5 6 7 8 9 10
Unemployment
Rate

7. Refer to figure 35-2. In this order, which curve is a long-run Phillips curve and
which is a short-run Phillips curve?
a. A, B
b. A, D
c. C, B
d. D, A
e. A, C
8. An adverse supply shock will have which of the following combinations of events?
Aggregate Supply Price Level
Real Output
A.
shift right
increase
increase
B.
shift right
increase
decrease
C.
shift right
decrease
decrease
D.
shift left
increase
increase
E.
shift left
increase
decrease
a. A
b. B
c. C
d. D
e. E
9. An adverse supply shock causes inflation to
a. rise and the short-run Phillips curve to shift right.
b. rise and the short-run Phillips curve to shift left.
c. fall and the short-run Phillips curve to shift right.
d. fall and the short-run Phillips curve to shift left.
e. fall and the long-run Phillips curve to shift right.
10. Suppose that a small economy that produces mostly agricultural goods experiences a
year with exceptionally good conditions for growing crops. The good weather would
a. shift both the short-run aggregate supply and the short-run Phillips curve right.
b. shift both the short-run aggregate supply and the short-run Phillips curve left.
c. shift the short-run aggregate supply curve to the right, and the short-run Phillips
curve to the left.
d. shift the short-run aggregate supply curve to the left, and the short-run Phillips
curve to the right.
e. shift the short-run aggregate supply curve to the right, and cause a movement
along the existing Phillips curve downward and to the right.

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11. Disinflation is defined as a

a. zero rate of inflation.
b. constant rate of inflation.
c. reduction in the rate of inflation.
d. negative rate of inflation.
e. high rate of inflation.
12. During the middle and last part of the 1990s, both inflation and unemployment were
low. In general, this could have been the result of
a. adverse supply shocks that shifted the short-run Phillips curve left.
b. adverse supply shocks that shifted the short-run Phillips curve right.
c. favorable supply shocks that shifted the short-run Phillips curve left.
d. favorable supply shocks that shifted the short-run Phillips curve right.
e. favorable supply shocks that shifted the long-run Phillips curve right.

Free Response Questions

1. In the long run, what primarily determines the natural rate of unemployment? In the
long run, what primarily determines the inflation rate?
2. Suppose that the prime minister and parliament of Veridian are disappointed with the
high inflation rates under the current system where the Veridian Ministry of Finance is
in charge of the money supply. They make reforms to lower inflation from its current
rate of 8 percent. Suppose further that the public is confident that with the reforms
in place that inflation will fall to 2 percent. Also suppose that those in control of the
money supply actually conduct monetary policy so that the actual inflation rate is 4
percent. Using long-run and short-run Phillips curves and assuming the natural rate
of unemployment is 6 percent, show the initial long-run equilibrium of Veridian and
label it A. Assuming that the government had actually set inflation at 2 percent and
that the public believed this, label the long-run equilibrium B. Now, suppose that
inflation expectations fell to 2 percent and that the government unexpectedly created
inflation of 4 percent. Show the short-run equilibrium and label it C. If the money
supply continues to grow at a rate consistent with 4 percent inflation, show where the
economy ends up and label that point D.

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THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

Solutions
Multiple-Choice Questions
1. c TOP: Phillips curve
2. b TOP: Aggregate demand and supply | Short-run Phillips curve
3. e TOP: Expansionary policy
4. d TOP: Short-run Phillips curve
5. a TOP: Phillips curve
6. b TOP: Long-run Phillips curve | Natural rate of unemployment
7. b TOP: Short-run Phillips curve | Long-run Phillips curve
8. e TOP: Supply shocks
9. a TOP: Short-run Phillips curve shifts | Supply shocks
10. c TOP: Short-run Phillips curve shifts | Supply shocks
11. c TOP: Disinflation
12. c TOP: Supply shocks | Short-run Phillips curve shifts

Inflation
Rate

Free Response Questions

1. In the long run, the natural rate of unemployment is primarily determined by labor market factors, including
government policy concerning minimum wages and unemployment benefits. In the long run, inflation is
primarily determined by money supply growth.
TOP: Inflation | Natural rate of unemployment | Classical dichotomy
2. A correctly drawn Phillips curve will have inflation on the vertical axis and unemployment on the horizontal
axis.The initial long-run equilibrium would be drawn at A where the vertical long-run Phillips curve intersects
the short-run Phillips curve at an inflation rate of 8 percent. The new long-run and short-run equilibrium
created when the government set inflation at 2 percent and the public believed this would happen is shown by
point B. If the government unexpectedly created an inflation of 4 percent, there would be a movement along
a short-run Phillips curve to point C. If the money supply grows at a rate consistent with a 4 percent inflation
rate, a new long-run equilibrium would be established at point D.
12
11
10
9
8
7
6
5
4
3
2
1

D
B

1 2 3 4 5 6 7 8 9 10 11 12 13 14
Unemployment
Rate
Veridian Phillips Curves

TOP: Short-run Phillips curve shifts | Long-run Phillips curve

365