Inflation and Employment
A problem arises when monetary policy is used to reduce inflation. There is a short term trade-off between unemployment and inflation. In 1958, economist A. W. Philips published an article showing that when inflation is high, unemployment is low, and vice versa. This relationship, when graphed, came to be known as the Phillips curve. When monetary policy is used to reduce inflation, either by contracting the money supply or by raising interest rates, this reduces aggregate demand, while aggregate supply remains the same. When aggregate demand decreases, prices decrease, but unemployment rises.
Short-Term Influence of Inflation on Employment — the Phillips Curve
Although the unemployment rate fluctuates, it trends toward a natural equilibrium known as the natural rate of unemployment, which is the unemployment rate that would prevail when there have not been any recent changes to monetary policy, when economic output is optimal. The natural rate of unemployment includes frictional unemployment, which is the unemployment that results because it takes time to find another job or a new job, and structural unemployment, which results from a mismatch of the skills that the labor force provides and what the job market demands. The other component of unemployment is cyclical unemployment, which is the unemployment that results when there are fewer jobs than members of the labor force.
Although the natural rate of unemployment cannot be lowered by monetary policy over the long-run, cyclical unemployment can be reduced, at least temporarily, through monetary policy.
It was Milton Friedman and Edmund Phelps who showed that the Phillips relationship between unemployment and inflation was valid over the short run but not over the long run. Over the long run, the natural rate of unemployment would be unaffected by prices. This accords with the principle of monetary neutrality, which simply states that nominal quantities, such as prices, cannot affect real variables, such as output and employment. If prices go up, incomes generally follow.
Hence, the long-run Phillips curve is vertical, which means that it does not depend on money growth or inflation in the long-run; instead, it depends on the natural rate of unemployment, which, itself, can change over time due to changes in minimum wage laws, collective bargaining, unemployment insurance, job training programs, and changes in technology.
Friedman and Phelps concluded that expected inflation is what changed the short-term relationship between unemployment and inflation into the long-term natural rate of unemployment. Expected inflation causes people to demand greater wages so that their incomes will keep pace with inflation. By increasing the cost of labor, the short-term increase in employment is reversed back to the natural rate of unemployment. This relationship is summarized in the natural rate hypothesis, which states that unemployment eventually returns to its normal, or natural, rate, regardless of the inflation rate. The short-term unemployment rate can be approximated by the following equation, where p equals a modifying parameter:
Unemployment Rate = Natural Rate of Unemployment – p × (Actual Inflation – Expected Inflation)
Sometimes the increase in prices results from an increase in the inputs to production, so called supply shocks, such as the increase in the price of oil in 1974, when the Organization of Petroleum Exporting Countries (OPEC) began increasing prices by restricting supply. This increased unemployment by reducing the demand for labor. When prices rise because of the greater cost of the factors of production, it is sometimes referred to as stagflation, since there is inflation even though economic output is falling.
Because inflation is caused by decreasing aggregate supply rather than an increase in aggregate demand, the relationship between unemployment and inflation is reversed in stagflation. Nonetheless, the natural rate of unemployment will prevail over time, under both stagflation and demand inflation.
In the early 1980s, Paul Volcker, who was chairman of the Federal Reserve, decided to reduce the money supply to fight inflation, to pursue a policy of disinflation, which is a reduction in the rate of inflation. (Note that this differs from deflation, when prices actually fall.) However, he was uncertain about the consequences on unemployment.
Many economists believed that to reduce inflation, there had to be some unemployment. The number of percentage points of annual output that would be lost in reducing inflation by 1% came to be known as the sacrifice ratio. Many believed that the sacrifice ratio was typically 5. In other words, the central bank would have to accept a 5% reduction in output for each percentage point of inflation, with the resulting increase in the unemployment rate.
Rational Expectations Hypothesis and the Lucas Critique
There were many economists, such as Robert Lucas, Thomas Sargent, and Robert Barro, who believed that the sacrifice ratio would not be that high because people had rational expectations, which could be modified by the government so that the short term trade-off between unemployment and inflation reduction would not be as severe. The rational expectations hypothesis simply states that people will use all of the information they have, including information about government policies, when forecasting the future. Households, firms, and other organizations make decisions based on their future expectations of the economy. Consequently, how soon the unemployment rate would return to its natural rate would depend on how quickly people modify their expectations of future inflation.
Statistical models that were used to forecast the effects of monetary policy changes also had to be modified, since they relied on historical data that only incorporated how the economy responded to monetary policy changes in the past. In what became known as the Lucas critique, incorporating historical information about monetary policy changes and their effects was not enough to predict the consequences of changes to present monetary policy. Econometric models would have to incorporate changes in the behavior of economic agents, i.e. consumers and businesses, to changes in the monetary policy.
Consequently, during the 1970s, Lucas applied the rational expectations hypothesis to econometrics, which is the statistical analysis of economic policy, so that they would be more accurate in predicting the response of the economy to changes in monetary policy.
Volcker succeeded in reducing inflation from 1981 to 1987; however the unemployment rate peaked at 10% in the process of doing so, going from 7% to 10% in 1982 to 1983, then falling back to 7% in 1986 and 6% in 1987.
Even though unemployment did rise under the central bank's contraction of the money supply, the rational expectations hypothesis still had supporters, both because the unemployment did not rise as high as some have predicted and because the public did not believe that Volcker would be successful in reducing the inflation rate. Hence, many economists believed that by having a firm policy of containing inflation, the public will have reduced expectations of future inflation, which would allow a more favorable compromise between unemployment and inflation.