Back To CourseEconomics 102: Macroeconomics
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Jon has taught Economics and Finance and has an MBA in Finance
In the United States, President Richard Nixon had come to office in 1968 with a pledge to bring down inflation, which was between 4% and 5% - higher than it had been since 1951. His economic advisors, using the knowledge that they had at the time, told him that if the government pursued policies that slowed the economy, then inflation would go down, and unemployment, which was already low, would move back up a little bit. Shortly thereafter, the government changed its fiscal policy by reducing government spending in an effort to cool the economy.
Unfortunately, things didn't turn out the way that they predicted. The President and his advisors were shocked when unemployment rose and inflation rose from 4.8% to 5.3%! Not only did these events catch the President and major economists off guard, they stirred up a great debate in the field of macroeconomics that led to some major advances in how economists model the growth of the economy. So what was going on during this time? For the rest of this lesson, we'll find out.
First, let's take a historical look at what led to the economic thinking of that time. In 1958, when A.W.H. Phillips released a study of wages in the United Kingdom, he found that there was an inverse relationship between inflation and unemployment. In other words, when unemployment was high, inflation was low, and when unemployment was low, inflation rose rapidly. Economists call this the Phillips curve. The Phillips curve illustrates the relationship between the rate of inflation and the unemployment rate. The Phillips curve tells us that it may not be possible for an economy to achieve both of the goals of low inflation and low unemployment at the same time.
In the U.S. economy of the 1960s, it appeared that there was a definite tradeoff between the two. It appeared that the government leaders had succeeded in lowering the unemployment rate, but only at the expense of higher inflation. Soon after this discovery, economists began estimating what the Philips curve would be for most other countries, and this theory became widely accepted and taught in major universities across the world. While the Phillips curve held true throughout the entire decade of the 1960s, it fell apart in the early 1970s. Go with me to the town of Ceelo for some more specific examples from everyday life and see the Phillips curve in action.
When Bob's low-rider lawn service feels the effects of an expanding economy, they hire additional employees and raise prices in order to meet the additional demand. When Bob's business feels the pains of a slowing economy, they lay workers off and lower prices in order to adjust to less demand. This is why prices across the economy tend to be higher when unemployment is low and lower when unemployment is high. This is the Phillips curve in action. But while this relationship holds in the short run, it falls apart in the long run.
Let's explore what happens to inflation and unemployment in the long run, first from the standpoint of an expanding economy and then from the standpoint of a recessionary economy.
When the economy is expanding, that means consumers are buying more goods and services - including Bob's lawn service. Bob has hired new employees like other businesses across the economy, so prices are higher and unemployment is lower than usual in the short run. Let's say he has 15 workers and he can mow 150 lawns per week. When businesses like Bob's hire new workers all across the economy, a shortage of workers develops. Not only that, but the workers figure out that prices for goods and services have gone up and they start demanding higher wages. All of a sudden, Bob gets a voicemail from Jerry saying he can't pay his bills and he needs a raise. Then he gets a text message from Doug saying he wants a raise from $10 per hour to $12 per hour or he's long gone. Pretty soon, all his employees get wise and start asking for a raise. Now he has to raise the wages he pays to everyone just to keep them from leaving to work for Jimbo's lawn company down the road (who have slightly better seats on their mowers). These added costs lower Bob's profit and influence him to lay off 5 workers in order to maintain his profit margin. Now, instead of 15 workers, Bob only has 10 workers and can only mow 100 lawns per week.
Eventually, however, a shortage of workers develops and workers begin to demand higher wages. When businesses are forced to pay higher wages, what they do instead is lay off workers to protect their profit margins, and that means that the unemployment rate rises back to its natural rate. While economists illustrate an increase in demand as movement along the short-run Phillips curve, they illustrate this long-run scenario we just talked about as a shift of the entire short-run Phillips curve towards the natural rate of unemployment. On the graph, this is shown by moving from point B to point C.
Now let's look at things from the opposite point of view. When the economy is in recession, this means that consumers are buying fewer goods and services - including Bob's lawn service. Responding to lower demand, businesses like Bob's lay off workers all across the economy and prices go down. Instead of 10 workers, Bob now has 7 workers, let's say, which means that in this example he can only mow 75 laws instead of 100.
While unemployment is higher in the short-term, in the long run, things change. Let's look at Bob's business and see how this process unfolds. When unemployment builds up, eventually a surplus of workers develops, and this puts downward pressure on wages. At Bob's low-rider lawn service, Doug, Jerry and James have all applied to work for Bob, and they're all competing for the same position riding a commercial lawnmower. On Tuesday, let's say, Bob receives a gift package delivered to his house with two bottles of his favorite barbecue sauce. On the card, it says 'Your friend forever, Doug.' On Wednesday, Bob opens his mailbox after a hard day at work and finds he is now getting issues of Sports Illustrated courtesy of Jerry. The next day, Bob finds a gift certificate from Outrageous Bodacious Chicken Wings on top of his mower when he starts work. These workers really want this job!
When workers compete with each other for the same jobs, they start accepting lower wages, which means eventually Bob can pay his workers less as this trend filters through the economy. The bright side of lower wages, for Bob at least, is that he can lower the price of his lawn service from, say, $25 to $20 per cut, and this attracts 25 new customers. These new lawn service customers make it necessary for Bob to hire back the employees he previously fired. Now Bob is mowing 100 lawns per week again.
Economists illustrate a decrease in demand as movement down the short-run Phillips curve, shown here as moving from point A to point B. They illustrate this long-run scenario we just talked about as a shift of the entire short-run Phillips curve towards the natural rate of unemployment. On the graph, this is shown by moving from point B to point C.
A stronger economy led to lower unemployment in the short run, but unemployment eventually returned to its natural rate and wages and prices were higher. On the other hand, a weaker economy led to higher unemployment in the short run, but unemployment eventually returned to its natural rate and wages and prices were lower. While there is a definite tradeoff between unemployment and inflation in the short run, in the long run, there is no such tradeoff. Because unemployment always returns to its natural rate in the long run, the long-run Phillips curve is vertical at the natural rate of unemployment.
You can see this vertical line here on the graph. This is called the long-run Phillips curve, and it's drawn on the graph at what economists also call the natural rate of unemployment. The natural rate of unemployment is the rate of unemployment at which inflation does not increase or decrease. In other words, the price level in the economy is stable when unemployment is at a certain level.
This natural rate is the tipping point or the threshold between these two scenarios, and it's when inflation is stable. Why is it the tipping point? Because this is when actual inflation is equal to expected inflation. What do I mean by that? It's when workers and businesses are not expecting higher inflation; they are expecting inflation this year to be the same as last year. But when inflation expectations are rising or they're falling, the short-run Phillips curve shifts.
The pattern of the short-run Phillips curve held true throughout the entire decade of the 1960s. However, it fell apart in the early 1970s when inflation expectations began to change. This is the lesson that economists learned in the early 1970s. Expectations about the future inflation rate were the missing link in the original Phillips curve theory. Workers will change their expectations when they encounter higher or lower inflation, and when they do, the unemployment rate will return to its natural rate. The long-run Phillips curve is therefore vertical.
Let's review. The Phillips curve illustrates the relationship between the rate of inflation and the unemployment rate. When economic output falls, unemployment temporarily rises above the natural rate and the price level goes down. This is the inverse relationship between unemployment and prices that economists call the short-run Phillips curve.
Eventually, though, a surplus of workers develops, which leads to lower wages as workers start accepting lower pay. Businesses find they can lower prices to attract new sales and are able to increase hiring. This causes unemployment to move back to its natural rate in the long run. This process also works in reverse. When economic output rises, businesses expand to meet higher demand by hiring additional workers. Prices also go up because of this new demand, and the unemployment rate falls below the natural rate temporarily.
Eventually a shortage of workers develops, and workers begin to demand higher wages. When businesses are forced to pay higher wages, they instead lay off workers to protect their profit margins and the unemployment rate rises back to its natural rate. Although there is a tradeoff between unemployment and inflation in the short run, there isn't one in the long run. Workers will change their expectations when they encounter higher or lower inflation, and when they do, the unemployment rate will return to its natural rate. The short-run Phillips curve is therefore downward-sloping, while the long-run Phillips curve is vertical.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 123 lessons
Next LessonInflation & Unemployment Relationship Phases: Phillips, Stagflation & Recovery