曼昆第10版讲义mankiw10e-irm-ch14

|CHAPTER14 AggregateSupplyandtheShort-RunTradeoffBetweenInflationandUnemployment

LectureNotes|

CHAPTER14

AggregateSupplyandtheShort-RunTradeoffBetweenInflationandUnemployment

NotestotheInstructor

ChapterSummary

Thischaptersummarizescurrentresearchonaggregatesupply.Itisdividedintotwoparts.Thefirstpartpresentstwoprominentmodelsofaggregatesupply,emphasizingtheircommonconclusionthatoutputdiffersfromthenaturalrateifpricesdifferfromexpectedprices.Themodelsarebasedonimperfectionsingoodsmarketsthatinvolvestickypricesorincompleteinformation.ThesecondpartmovesfromaggregatesupplytothePhillipscurveandusesthisasatoolfordiscussingpolicyquestionssuchasthecostsofdisinflation.

Comments

Thischapterisoneofthetextbook’srealstrengths.Thesynthesisofthetwomodelsofaggregatesupplybringssomeunitytoanareainmacroeconomicsinwhichthereisastrikinglackofconsensus.Fromthepointofviewofexplanation(thoughperhapsnotofpolicy),itisveryhelpfultodrawoutthesimilaritiesbetweentheLucasimperfect-informationmodelandnewKeynesiantheoriesofstickyprices.(InstructorswhowishtopursuethepolicyimplicationsofthesemodelsinmoredetailcoulduseSupplement14-7onpolicyineffectiveness.)

Instructorscansavetimeinthischapterbynotpresentingbothmodelsofaggregatesupplyandinsteademphasizingthesupplyequationcommontoallthemodels.Thematerialinthischapterrequiresabouttwolectures.

UseoftheEWebsite

GototheEwebsiteanddownloadmonthlydataoverthepast10yearsfortheU.S.consumerpriceindex,bothfortheoverallindexandthecoreindexthatexcludesfoodandenergyprices.Computethe12-monthinflationrate(i.e.,DecembertoDecember,JanuarytoJanuary,etc.)tosmoothoutmonth-to-monthvolatilityininflation.Comparethemeasureofinflationfortheoverallindexwiththemeasureforthecoreindex.Explainhowonemightinterpretperiodswherethesemeasuresaresignificantlydifferentfromeachotherasperiodsduringwhichsupplyshocksoccurred.Discusshowtheseshocksmayhaveshiftedtheshort-runaggregatesupplycurveandPhillipscurvefortheeconomy.

ChapterSupplements

Thischapterincludesthefollowingsupplements:

14-1 TheSticky-WageModel

14-2 RealWagesovertheBusinessCycle

14-3 TheWorker-MisperceptionModel

14-4 AnticipatedandUnanticipatedMoney(CaseStudy)

14-5 IsPriceFlexibilityStabilizing?

14-6 HowLongIstheLongRun?PartIII

14-7 PolicyIneffectiveness

14-8 DidtheNAIRUDeclineinthe1990s?(CaseStudy)

14-9 CostsofDisinflation(CaseStudy)

14-10 TheUnequalCostsofDisinflation(CaseStudy)

14-11 “ThePoincaréMiracle”

14-12 HysteresisandtheLong-RunPhillipsCurve

14-13 UnemploymentintheUnitedKingdominthe1980s

14-14 AdditionalReadings

LectureNotes

Introduction

TheIS–LMmodelisausefulandversatilemodeloftheeconomyintheshortrunwhenpricesarefixed,andwecouldspendalongtimeanalyzingitsproperties.Modernmacroeconomics,though,treatsIS–LMasonlypartoftheexplanationofshort-runfluctuations:itisatheoryofaggregatedemand,whichmustbecombinedwithaggregatesupplytoobtainacompletepictureoftheeconomy.Thereasonforthisisthattheassumptionofcompletepricestickiness,withitsimplicationofahorizontalshort-runaggregatesupplycurve,isveryunsatisfactory.ModernmacroeconomicsthusspendslesstimeworryingaboutthenicetiesoftheIS–LMmodelandinsteadfocusesitsattentionontryingtoexplainaggregatesupplyintheshortrun.Muchrecentresearchinmacroeconomicsisonaggregatesupply.Sincewearelookingatrecentresearch,thereislessconsensusamongmacroeconomistsastowhatconstitutesthebestmodelofaggregatesupply.Rather,thereareanumberofcompetingmodelsthatnonethelesssharemanycommonelementsandcometomoreorlessthesameconclusion.

14-1 TheBasicTheoryofAggregateSupply

Thischapterintroducesanupward-slopingshort-runaggregatesupply(SRAS)curve.Asaresult,changesinaggregatedemandwillnowaffectnotonlyoutputintheshortrunbutalsothepricelevel.Theupward-slopingSRAScurvearisesdueto“frictions”intheeconomythatwehavethusfarignored.

Ourbasicshort-runaggregatesupplyequationis

whereαissomenumbergreaterthanzeroandEPrepresentssomeexpectationofthepricelevel.Thisequationsaysthatoutputmaydifferfromitslong-runnaturalrateiftheactualpricelevelturnsouttobedifferentfromthepricelevelthatpeopleanticipate.Notethreeimplicationsofthisequation.First,theaggregatesupplycurveslopesupward.Second,thepositionoftheaggregatesupplycurvedependsuponEP:theSRAScurveintersectstheLRAScurveatapricelevelequaltoEP,soahighervalueofEPshiftstheaggregatesupplycurveupward.Third,theparameterαmeasureshowmuchdifferencesbetweenactualandexpectedpricesinfluenceoutput.Ifα=0,theaggregatesupplycurveisvertical;ifαbecomesverylarge,theSRAScurveisalmosthorizontal,asinourearlieranalysis.

WeconsidertwoprominentmodelsthatexplainwhywemightgetsuchanSRAScurve:(1)thesticky-pricemodeland(2)theimperfect-informationmodel.Thesemodelshighlightdifferent“frictions,”andbothcontainsomeelementofthetruth.

TheSticky-PriceModel

First,weturntothesticky-pricemodel.Thismodelisthemostwidelyacceptedexplanationforanupward-slopingSRAScurve.Themodelhighlightshowfirmsmaysometimessetpricesbylong-termcontractswiththeircustomersor,intheabsenceofsuchcontracts,holdpricesconstantsimplybecausetheydon’twanttooffendtheircustomerswithfrequentpricechanges.Stickypricesalsomayresultbecauseitiscostlytoreprintcatalogsandpricelistsorbecausenominalwagesaresticky(perhapsduetosocialnorms),andfirmsbasetheirpricesonthecostsofproduction.

Thesticky-pricemodeltellsaverydifferentstoryofhowfirmsbehave.Uptonow,wehavealwaysthoughtoffirmschoosinghowmuchoutputtoproduce,takingasgiventhepriceatwhichtheycanselltheiroutput.Ifwereallywanttoexplainwhypricesmaybesticky,wehavetothinkaboutwhoactuallysetspricesandonwhatbasis.Inreality,firmsgenerallysetthepricesatwhichtheywanttoselltheiroutput.Toanalyzethissituationproperly,weneedmodelsofimperfectcompetitioninwhichfirmshavesomemonopolypower.Wedonotemphasizethispointyet,butwereturntoitlater.

Wesupposethatafirm’sdesiredpriceisdenotedbyp.Thispricedependsupontwothings.First,thegeneralpricelevel(P):thinkofthefirmashavingadesiredrealpriceinmindandthensettinganominalpricebasedontheoverallpricelevel;or,essentiallyequivalently,thinkofthefirm’sdesirednominalpriceasdependingonboththepriceschargedbyitscompetitorsandthecostofitsinputs.Ariseinthegeneralpricelevelcausesthesetoriseandinducesthefirmtowantahigherprice.Second,thefirm’sdesiredpricedependsuponthelevelofdemandintheeconomy.Anaturalwaytomodelthisistosupposethatthefirmwouldliketosetapriceequaltothegeneralpricelevelifdemandisatitslong-runlevel.Ifdemandishigher,thefirmwantsahigherprice.Wecansummarizethisas

Nowsupposethattherearetwotypesoffirmsintheeconomy.Onefraction(1–s)hasflexiblepricesandadjustsitspricestocurrenteconomicconditionsbasedonthisequation.Theotherfraction,s,ischaracterizedbystickyprices.Thatis,duetothecostsofpricesettingorsomeotherreason,theysetapriceinadvanceandkeepitinplaceforsomeperiodoftime.Theymustsetapriceonthebasisofexpectationsaboutfutureeconomicconditions.Thisinvolvesforecastingboththelevelofdemandandthepricelevel.Wewillsupposethattheirbestforecastaboutthelevelofdemandisthatitisatitslong-runlevel.Thisisconsistentwiththeideathattherearerandom,unforecastableshockstooutputthataverageouttozero.Thenfirmswithstickypricesjustset

p=EP.

Theactualpricelevelintheeconomyistheaverageofthesetwosetsofprices:

WecansolvethisforPtoobtain

Thisequationtellsus,first,thatifoutputisatitsnaturalrate,theactualandexpectedpricelevelscorrespond.Thismakessense.Sticky-pricefirmssimplysettheirpriceequaltotheexpectedpricelevel,whereasifoutputisatthenaturalrate,flexible-pricefirmssettheirpriceequaltotheactualpricelevel.Thesetogetherimplythattheactualpricelevelequalstheexpectedpricelevel.

Supplement14-1,“TheSticky-WageModel”

Supplement14-2,“RealWagesovertheBusinessCycle”

Thisequationalsoshowsthatifdemandishigh,sothatYexceeds,thentheactualpricelevelwillexceedtheexpectedpricelevel.Highdemandcausesflexible-pricefirmstoraisetheirprices.Ifallfirmswereflexible-pricefirms,thenthisstorycouldnotbeconsistent,sinceallfirmswouldbetryingtosetapriceabovetheaverage.Inotherwords,ifallfirmshadflexibleprices,itwouldneverbepossibleforYtoexceed.Thebehaviorofthesticky-pricefirmsservestoanchorthepricelevel.Theoverallresponseofthepriceleveltooutputshocksdependsuponthemixofthetwotypesoffirmsintheeconomy.

Whenwerearrangethisequation,wegetanaggregatesupplyequationwith

α=s/((1–s)a).

Theaggregatesupplyequationisflatter(outputhasagreaterresponsetopricechanges)whensisbigandaissmall.Whentherearemanysticky-pricefirmsintheeconomy,thepricewillbenearitsexpectedlevelevenwhenoutputisalongwayfromthenaturalrate.

Thisstoryofaggregatesupplyisinsomewaysverydifferentfromthenextone.Whiletheaggregatesupplycurvelooksessentiallythesame,theargumentisnotthatunexpectedlyhighpricesleadtohighoutputbutinsteadthatwhenoutputishigh,pricesalsotendtobehigh.Remember,however,thatboththepricelevelandtheoutputlevelareendogenousvariables.

AnAlternativeTheory:TheImperfect-InformationModel

Thesecondmodelofaggregatesupply,knownastheimperfect-informationmodel,assumesthatmarketsclear.Inotherwords,pricesandwagesarefreetoadjustsothatsupplyequalsdemandingoodsandlabormarkets.Themarketimperfectioninthismodelisatemporarymisperceptionaboutpricesthatcausestheshort-runaggregatesupplycurvetodifferfromthelong-runaggregatesupplycurve.RobertLucasdevelopedthemodelintheearly1970sasaformalizationoftheframeworksketchedbyMiltonFriedmaninhispresidentialaddresstotheAmericanEconomicAssociationin1968.SeeRobertE.Lucas,Jr.,"UnderstandingBusinessCycles,"StabilizationoftheDomesticandInternationalEconomy,vol.5ofCarnegie-RochesterConferenceonPublicPolicy(Amsterdam:NorthHolland,1977)andMiltonFriedman,“TheRoleofMonetaryPolicy,”AmericanEconomicReview58(March1968).

Forthisreason,theshort-runaggregatesupplycurveofthischapterissometimesreferredtoastheLucassupplycurve.

Supplement14-3,“TheWorkerMisperceptionModel””

Considerasituationinwhichproducersareunabletodistinguishperfectlybetweenashocktothepriceoftheirownoutput,whichwouldleadthemtoaltertheirproduction,andashocktothegeneralpricelevel,thebestresponsetowhichwouldbenochangeinproduction.Givensomepositivepriceshock,aproducer’sbestresponseissomewherebetweenthetwo,withtheexactdecisiononhowmuchextratoproducedependinguponhowprobableheregardseachtypeofshocktobe.

Moreprecisely,themodelassumesthatproducershavesomeexpectationofthegeneralpricelevel(EP).Theythenobservethepriceatwhichtheycanselltheiroutput.Ifthatpriceisunexpectedlyhigh,theymightconcludethatthepricesofallgoodshaveincreased(perhapsduetoanincreaseinthemoneysupply).Inthiscase,theyrevisetheirestimateofthegeneralpricelevelanddonotchangetheirproduction.Alternatively,theymightthinkthatthedemandfortheiroutputhasincreased,leadingthemtoproducemore.Anydifferencebetweentheactualandexpectedpricescouldbeduetoeitherorbothofthesepossibilities.Producersfaceasignalextractionproblem.Insuchcircumstances,thebestresponsetoanunexpectedpriceincreaseistoincreaseoutputbysomeamount.Theconclusionisbynowfamiliar:ifthepricelevelisabovetheexpectedpricelevel,outputisabovethenaturalrate.

Theimperfect-informationmodeldescribedinthischapterreliesonconfusionbetweenrelativepricesandtheaggregatepricelevel,asoriginallydevelopedbyNobelPrize–winningeconomistRobertLucas.Morerecentworkonimperfect-informationmodelsofaggregatesupply,however,hasemphasizedtheinabilityofpeopletofullyincorporateinformationabouttheeconomyintotheirdecisionsratherthanconfusionaboutpricechanges.Inotherwords,the“friction”thatresultsinanupward-slopingSRAScurveisnotthelimitedavailabilityofinformationbut,instead,thelimitedabilityofpeopletouseinformationthatisavailable.Thislimitedabilitytoprocessinformationleadspricesetterstorespondonlygraduallytochangesinmacroeconomicconditions.

CaseStudy:InternationalDifferencesintheAggregateSupplyCurve

Supplement14-4,“AnticipatedandUnanticipatedMoney”

Supplement14-5,“IsPriceFlexibilityStabilizing?”

Supplement14-6,“HowLongIstheLongRun?PartIII”

Supplement14-7,“PolicyIneffectiveness”

Theimperfect-informationmodelisbasedonthefactthatproducersmaybeunabletodistinguishperfectlybetweenshockstotheirownpriceandshockstothegeneralpricelevel.If,however,shockstothegeneralpricelevelpredominate,thenproducerswilltendtothinkthatanygivenchangeintheirpricewasprobablyduetosuchashockandwillnotchangeoutputsignificantly.Theconverseistrueifshockstoindividualprices(realratherthannominalshocks)predominate.Themodelthuspredictsthatincountrieswhereaggregatedemandfluctuatesagreatdeal,theaggregatesupplycurvewillbesteep(αwillbesmall).Lucasexamineddataformanydifferentcountriesandfoundevidencesupportiveofthetheory:aggregatedemandhadasmallereffectonoutputincountrieswherepriceswerehighlyvariable.

Chapter5pointedoutthatthereisawell-documentedthoughimperfectlyunderstoodcorrelationbetweenthelevelandvariabilityofinflation.Countrieswithhighlyvariableinflationarethuscountrieswhere,onaverage,inflationishigher.Wheninflationishigherthecostsoffixingnominalpricesinadvancewillbegreater,soindividualfirms’priceswilltendtobemoreflexible.AnotherexplanationofLucas’sfindingisthusthat,whenaggregatedemandismorevariable,fewfirmswillwanttosetpricesinadvance,andsotheproportionofsticky-pricefirmsintheeconomyissmaller.Asaconsequence,theaggregatesupplycurveissteeper.

Implications

Figure14-1

Figure14-2

Thetwomodelsofaggregatesupplydifferintermsofthemarketfrictiontheyemphasize.Thesticky-pricemodelemphasizesthatpricesmaynotmovetoequilibratesupplyanddemandintheshortrun.Theimperfect-informationmodelemphasizestheroleofinformationproblemsasanexplanationofshort-runfluctuations.Thesemodelstogetherprovidereasontobelievethatoutputwilldeviatefromthenaturalratewheneverpricesexceedtheirexpectedlevel.

Puttingthisaggregatesupplycurvetogetherwithaggregatedemand,wecanseethatanunexpectedincreaseinaggregatedemandwillleadtoanincreaseinbothoutputandpricesintheshortrun.Inthelongrun,priceexpectationswilladjustandtheaggregatesupplycurvewillmoveupward,implyingthatoutputwillreturntoitsnaturalrateatahigherpricelevel.

14-2 Inflation,Unemployment,andthePhillipsCurve

Policymakersaimtohavelowinflationandlowunemployment.Butthesegoalssometimesconflict.Apolicyofincreasingaggregatedemandbyexpansionarymonetaryorfiscalpolicieswillincreaseoutputalongtheshort-runaggregatesupplycurvebutalsoleadstoahigherpricelevel.Higheroutputimplieslowerunemploymentbecausebusinesseshiremoreworkerswhentheyproducemore.Ahigherpricelevel,however,implieshigherinflation—whichismeasuredastherateofchangeofthepricelevel.Asaresult,whenpolicymakersexpandaggregatedemandtheyincreaseoutput(andlowerunemployment)butalsoincreaseinflation.ThistradeoffbetweenunemploymentandinflationisknownasthePhillipscurve.

DerivingthePhillipsCurvefromtheAggregateSupplyCurve

In1958,theeconomistA.W.Phillipsnotedthattherewasaninverserelationshipbetweentheinflationrateandtheunemploymentrate.ThisrelationshipbecameknownasthePhillipscurveandisspecifiedas

π=Eπ–β(u–un)+ν,

whereunisthenaturalrateofunemployment,andνisasupplyshock.ToseehowthisisrelatedtotheSRAScurve,wefirstwritetheaggregatesupplycurveintermsofinflation:

(Tobeprecise,weshouldthinkabouttheshort-runaggregatesupplycurveasbeingspecifiedinlogterms.)Next,wecanuseOkun’slawtoarguethatpositiveoutputshocksareassociatedwithunemployment’sbeingbelowthenaturalrate:

π=Eπ–β(u–un).

Finally,themodernPhillipscurveisusuallyadjustedbyrecognizingthattherewillsometimesbeshockstothepricelevel—mostimportant,oilpriceshocks.Thusweget

π=Eπ–β(u–un)+ν.

ThePhillipscurveprovidesausefulwaytodiscussaggregatesupplybecauseitisframeddirectlyintermsoftwocloselywatchedmacroeconomicvariables,namely,inflationandunemployment.

FYI:TheHistoryoftheModernPhillipsCurve

IntheearlyyearsafterPhillipsfirstnotedtherelationshipbetweeninflationandunemployment,economiststhoughtthatitmightindicateasimple,stabletradeoffbetweeninflationandunemployment:lowerunemploymentcouldbeachievedonlyatthecostofhigherinflationandviceversa.Foratime,macroeconomicpolicyoptionswereoftendiscussedintermsofthisdifficultchoice.Macroeconomists’understandingofthePhillipscurvewasgreatlyincreasedinthe1960s,whenMiltonFriedmanandEdmundPhelpsemphasizedthatthenatureofthePhillipscurverelationshipshouldchangewhenexpectationsofinflationchange.Theexperienceofthe1970s,whenoilpriceshockshadabigimpactontheeconomy,ledeconomiststopaymoreattentiontosupplyshockswhenanalyzingthePhillipscurve.

AdaptiveExpectationsandInflationInertia

Moderntheoriesofaggregatesupply,assummarizedinthePhillipscurve,confrontamajordifficulty.TousethePhillipscurve,weneedtohavesomeideaofhowpeopleformexpectationsofinflation.Thisisadifficultproblem,becauseexpectationsarenotsomethingwecandirectlyobserve.Onepossibilityisthatpeoplelooktotherecentpast;thisisknownasadaptiveexpectations:

Eπ=f(πt–1,πt–2,...).

Asimpleexampleis

Eπ=πt–1.

Theconsequenceofthisisinertialinflation;weobserverisingpricesinpartbecausepeopleexpectrisingprices.

TwoCausesofRisingandFallingInflation

ThePhillipscurvealsotellsusthatinflationwillriseifunemploymentisbelowthenaturalrateoriftherearepriceorcostshocks.Inflationthatarisesbecauseoflowunemployment,thatis,(u–un)<0,iscalleddemand-pullinflation.Inflationthatarisesbecauseofsupplyshocksisknownascost-pushinflation.

CaseStudy:InflationandUnemploymentintheUnitedStates

Supplement14-8,“DidtheNAIRUDeclineinthe1990s?”

U.S.economichistoryfromthe1960stothe1990scanbesummarizedintermsofinflationandunemployment.Broadlyspeaking,inflationroseandunemploymentfellduringthe1960sbecauseofexpansionarymonetaryandfiscalpolicies.ThedataforthatdecadewerefairlyconsistentwiththeideaofastablePhillipscurve.Inthe1970s,however,unemploymentandinflationbothrose,duelargelytosupplyshocks.Bythestartofthe1980s,highinflationhadbeenaroundforanumberofyears,andinflationexpectationswerecorrespondinglyhigh.TheFederalReservepursuedpolicesaimedatdecreasinginflation,atthecostofasevererecession.Highunemploymentandfallingoilpricesdidindeedbringtheinflationratedown.Intheearly1990s,unemploymentroseandinflationfellduetoaggregatedemandshocks.Inthelatterhalfofthedecade,inflationcontinuedtodeclineevenasunemploymentfellto30-yearlows.Someeconomistsarguedthatthenaturalrateofunemploymenthadfallen,whileotherspredictedthatdemand-pullinflationwouldsoonreassertitself.Therecessionoftheearly2000sdampenedanyincipientinflationpressures.Astherecoverycontinuedthrough2004,inflationroseslightlyas

Figure14-3

unemploymentdeclined.Themuchmoresevererecessionthatbeganin2008seemedlikelytopushinflationsignificantlylower,withsomeobserversatthetimeconcernedthatpricesmightactuallyfall—asituationknownasdeflation.Asitturnedout,inflationdeclinedbutremainedabovezero.Oneexplanationisthatexpectationsofinflationstayedanchoredatabout2percentratherthanfalling,aswouldhavebeenpredictedbyadaptiveexpectations.ThereasonexpectationsremainedanchoredmayhavebeenduetotheFed'scredibilityaboutitstargetrateofinflation.

TheShort-RunTradeoffBetweenInflationandUnemployment

Figure14-4

Figure14-5

ThePhillipscurvedoesnotpresentpolicymakerswithapermanenttradeoffbetweeninflationandunemployment;weknowthat,inthelongrun,theinflationratedependsuponmoneygrowthandunemploymentwillbeatitsnaturalrate.Policymakersdofacesuchatradeoffintheshortrun,however.Byusingexpansionarymonetaryandfiscalpolicies,forexample,policymakerscouldincreaseinflationanddecreaseunemploymentintheshortrun.Thetheoriesofshort-runaggregatesupplyrevealthatsuchapolicywouldworkbyincreasingpricesabovetheirexpectedlevel.Ifexpectedinflationchanges,thePhillipscurveshifts.Inthelongrun,peoplerevisetheirpriceexpectations,andthereisnotradeoffbetweeninflationandunemployment.

FYI:HowPreciseAreEstimatesoftheNaturalRateofUnemployment?

ThePhillipscurveshowsthatinflationwilltendtoriseorfalldependingonwhethertheunemploymentisbeloworaboveitsnaturalrate.Butmeasuringthenaturalrateaccuratelyisdifficult.Estimatesofthenaturalrate—sometimesreferredtoastheNAIRU(fornon-acceleratinginflationrateofunemployment)—arefarfromprecise.Oneproblemisthatsupplyshockscancauseinflationtoriseevenwhentheunemploymentrateishigh,asweobservedinthemid-1970s.AnotherproblemisthatthenaturalratemaychangeovertimeforreasonsdiscussedinChapter6.Theseincludechangesinthedemographicstructureoftheworkforce,changesingovernmentpoliciessuchasminimumwagelawsorunemploymentinsurance,andchangesintheeconomy’sinstitutionssuchasthedeclineintheinfluenceoflaborunions.Onestudyhasfoundthatthenaturalratewas6.2percentin1990,butthestatisticalprecisioninthisestimatewassoweakthattheratecould,with95percentconfidence,beaslowas5.1percentorashighas7.7percent.Amorerecentstudyestimatesthenaturalrateat5.8percentin2013,witha95percentconfidenceintervalfrom4.5to7percent.

DisinflationandtheSacrificeRatio

Ifpolicymakerswishtodecreaseinflation,weknowfromthelong-runanalysisthattheymustdecreasethegrowthrateofthemoneysupply.Intheshortrun,suchamonetarycontractionwillcausearecession.Itisthennaturaltoaskhowcostlydisinflationislikelytobe.Thepercentageofayear’sGDPnecessarytoreduceinflationby1percentagepointiscalledthesacrificeratio.Althoughestimatesvarywidely,atypicalvalueforthisnumberisaround5.Inotherwords,toreducetheinflationrateby1percentagepointcostsabout5percentofayear’sGDP.

RationalExpectationsandthePossibilityofPainlessDisinflation

Wenotedearlierthatinflationmayhaveaninertialcomponent:highinflationpersistsinpartbecausepeopleexpectit.Iftherewasawaytomakepeoplerevisetheirexpectationofinflationdownward,itwouldseempossibletoreduceinflationwithoutthelargecostsimpliedbytheestimatesofthesacrificeratio.Tostatethisanotherway,thePhillipscurveisconsistentwithunemployment’sremainingatitsnaturalratewhileactualandexpectedinflationfalltogether.

Ifexpectationsofinflationarerational(peoplebasetheirforecastsonallavailableinformation)ratherthanadaptive,suchpainlessdisinflationmaybepossible.Inparticular,iftheFedcanconvincepeoplethatitisgoingtoreducethegrowthrateofthemoneysupply,thenpeoplewillexpectlowerinflationandwill,therefore,setlowerpricesandwages.ProvidedthattheFedbehavesaspromised,lowerinflationwillbeachievedwithoutcostlyunemployment.ThepracticaldifficultywiththisapproachisthattheFed'spolicyannouncementmaynotbecredible(inpartforreasonsconsideredinthenextchapter).Nevertheless,theideaofrationalexpectationsteachesthatexpectationsofpolicieswillingeneralaffecttheperformanceoftheeconomy,andthesuccessofpoliciesmaydependinpartuponthecredibilityofpolicymakers.

CaseStudy:TheSacrificeRatioinPractice

Table14-1

Supplement14-9,“CostsofDisinflation”

Supplement14-10,“TheUnequalCostsofDisinflation”

Supplement14-11,“ThePoincaréMiracle”

TheVolckerdisinflationoftheearly1980spermitsanestimateofthesacrificeratio.Between1982and1985,inflation,asmeasuredbytheGDPdeflator,fellby6.1percentagepoints.Overthesameperiod,unemploymentexceededthenaturalratebyacumulative10percentagepoints.UsingOkun’slaw,thistranslatesinto20percentagepointsofannualGDP,givingasacrificeratioof3.3.TherelativelylowvalueofthissacrificeratiomayreflectPaulVolcker’sperceivedhighcredibility.YetnotevenVolckerwasabletoinfluenceinflationexpectationssufficientlytoengineerapainlessdisinflation.Indeed,thisreductionininflationresultedinthemostsevereeconomicdownturnatthetimesincetheGreatDepression.

HysteresisandtheChallengetotheNatural-RateHypothesis

Thetheoryofhysteresissuggeststhatthenaturalrateofunem