Archive for the 'Unemployment' Category

Feb 27 2013

Sequestration – a basic economic analysis

Ben Bernanke Lectures Congress on Austerity Economics : The New Yorker

In just two days, the United States will enact a massive contractionary fiscal policy known as the “sequester”, which includes over $1 trillion in federal spending cuts rolled out over the next ten yeas. The imminent sequester (which is defined as “to isolate, or hide away”) is the result of the failure of Democrats and Republicans to agree upon an acceptable combination of spending cuts and tax increases to put the US government on a more sustainable budgetary path (meaning lower national debt in the future). The sequester was never intended to occur, rather it was put in place to force the two parties to come up with a budget compromise that would cause less harm to the economy than the cuts that the sequester will impose.

The $1.2 trillion cut in spending will have several negative effects on the US economy, including 

…up to 2,100 fewer food inspections, 373,000 mentally ill adults and children going without treatment, 70,000 kids being kicked out of preschool, 2,700 schools losing federal funding, about 30,000 teacher layoffs, a reduction in federal law enforcement capacity equivalent to the loss of 1,000 federal agents, 1,000 fewer criminal prosecutions, and the list goes on and on. The chairman of the Joint Chiefs of Staff, Gen. Martin Dempsey, recently said before the Senate Armed Services Committee that sequestration will “make it much harder for us to preserve readiness after more than a decade of fighting in Iraq and Afghanistan.”

The effects on national output and employment in the US economy, which is still recovering from the Great Recession of 2009, will likely be devastating. According to the Federal Reserve Bank Chairman Ben Bernanke,

“Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant… Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run.”

Bernanke, a Republican himself, recognizes that any cut in government spending (known as a contractionary fiscal policy) will harm the US economy’s growth potential both in the short-run and the long-run. Bernanke believes that the primary goal of the government right now (and the Central Bank, which he is the head of) should be to promote increased employment to bring the nation’s unemployment rate down (back to its natural rate).

So what is the argument FOR a contractionary fiscal policy? Why would the Democrats and Republicans let this sequestration take place even when America’s leading economic voice is calling for it to be avoided? If you ask many of the Republicans in Washington, D.C., America’s biggest macroeconomic problem is not slow growth or high unemployment, it’s the large national debt. The debt (which is the sum of all of the country’s past budget deficits), has grown to nearly 80% of the nation’s GDP. This means that the nation owes the holders of that debt nearly as much as its total income in a year. If an individual had a debt level this high, that individual would probably have to cut back on his own spending (cut up those credit cards!), to begin paying back that debt; obviously, high personal debt ultimately leads to a decrease in the standard of living of the indebted person as it eventually has to be paid back.

But a nation’s debt is a little different than that of an individual. If the US government cuts back on spending to reduce the debt, the result is rising unemployment, lower incomes, reduced confidence among households and firms, a reduction in economic growth, and possibly, a recession. The goal of reducing the debt could ultimately reduce the national output and income, which could ironically make the debt an even bigger deal than it already is. Let me explain why.

Imagine two countries, Country A and Country G. Country A has a national debt of $12,000 billion dollars. Country G has a national debt of $355 billion dollars. Obviously, Country A’s debt is around 35 times the size of Country G’s. So if I asked you, which of these countries is facing a “debt crisis”, you’d probably say Country A, right? Well, you’d be wrong. Country A is America, and Country G is Greece. So why does Greece’s national debt of $355 billion, which represents 182% of Greece’s GDP of $195 billion, constitute a “crisis”, while America’s debt of $1,200 billion, or just around 80% of its GDP, is simply a cause of concern among one of the country’s political parties? The answer is, it’s not how large a nation’s debt is in dollar terms that matters, rather how large the debt is relative to the country’s GDP. A millionaire could handle a $100,000 debt just fine, while for an individual earning minimum wage, a debt of $100,000 would present a crushing burden that is unlikely ever to be overcome without that individual declaring himself bankrupt.

If the sequestration takes place, America’s GDP may fall, as Bernanke has warned. But its debt will continue to grow (albeit less slowly than it would without the sequester). If the GDP falls while the debt grows, the country’s debt burden actually increases, despite the desired outcome of the sequester, a reduction in debt. In other words, the sequestration will make America more like Greece (the guy on minimum wage) and less like America (the millionaire!).

Rather than working towards debt reduction, as the mainstream of the Republican party advocates, Ben Bernanke would prefer the federal government focus on policies that reduce unemployment. Unemployment, defined as “the state of actively seeking a job, but being unable to find one”, has several negative effects on individuals and the economy as a whole. Here’s Bernanke explaining to the US Congress the consequences of unemployment:

High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole. Lengthy periods of unemployment and underemployment can erode workers’ skills and attachment to the labor force or prevent young people from gaining skills and experience in the first place—developments that could significantly reduce their productivity and earnings in the longer term. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending, thereby leading to larger deficits and higher levels of debt.

Many economists believe that America’s huge national debt (in dollar terms) is really not all that bad when compared to its even huger GDP. A nation’s debt really only becomes a problem when that nation, like an individual burdened with a high level of personal debt, is forced to reduce its spending and begin paying that debt off. A nation can maintain a high level of debt as long as it can continue to borrow more money to pay off its past debt. And in the current global economy, no nation can borrow money more easily than the United States of America.

The cost of borrowing money is the interest rate that must be paid on loans made to an individual or government. At present, the US government can borrow money at very low interest rates (it pays between 1% and 3% on most of the government bonds it issues). This fact indicates that America’s debt, while it is a primary concern of the Republican party, is not a major concern among those to whom the US government owes money, nor to those who may lend it money in the near future.

The tradeoff America faces as it enters this period of sequestration, government spending cuts, and the resulting reduction in aggregate demand, income, output and employment, is one between future debt and future prosperity. The sequester may reduce the level of debt in the future, but it will also increase the debt burden (as Bernanke explained). In exchange for a smaller dollar value of its debt, America may have to accept  increased unemployment and a slower recovery from the Great Recession, which together will make the US less competitive, reduce standards of living, and make it more difficult for future generations to enjoy the quality of life experienced by their parents and grandparents.

Discussion Questions:

  1. What is the Unemployment Rate in the United States today? What is thought to be the US’s “natural rate of unemployment” How is unemployment measured (simply state the formula)?
  2. Based on America’s current unemployment rate, where would you expect the US to be on its business cycle? Draw a business cycle model and indicate where the US is most likely to be.
  3. Based on America’s current unemployment rate, where do you think current US equilibrium output is compared to full employment output? Draw an AD/AS model and indicate the likely equilibrium the US is currently experiencing.
  4. If you were in charge of fiscal policy, identify two possible policy recommendations that the US should consider given its current level of unemployment. Explain how each would impact the level of unemployment in the economy.
  5. Assume the marginal propensity to consume in the United States is 0.6, and the government decides to cut military and domestic spending by $85 billion. Calculate the effect this will have on America’s GDP.
  6. On the business cycle and AD/AS diagram you drew above, show the effect of the $85 billion spending cut.
  7. Explain how the spending cut will will impact the level of unemployment in the economy.
  8. Discuss with your table the wisdom of the $85 billion spending cut described above.

No responses yet

Sep 20 2012

Measuring the Macroeconomic Objectives – research activity

The activity below is to introduce Economics students to the three primary Macroeconomic objectives of any government or policy making body. These are :

Full employment of the nations work force: This means that nearly everyone who wants to work in the country is able to find a job. It does not mean that there is no unemployment, rather that the unemployment that does prevail in the economy is voluntary, i.e. it exists because workers are simply not willing to work at the prevailing wage rate. If there is involuntary unemployment in the economy, then the country is not meeting its macroeconomic objective, and there is likely a recession caused by a lack of overall demand (aggregate demand) for the nation’s goods and services.

Resources for learning about Full Employment:

Price level stability: Changes in the average price level of goods and services in the nation are measured by calculating inflation, commonly using a consumer price index to do so. Low and stable inflation is one of the macroeconomic objectives since price level volatility (high inflation or deflation) has several harmful effects on a nation’s households and business firms. Keeping inflation low and stable promotes a healthy environment for achieving business investment, full employment and economic growth

Resources for learning about Price level stability:

Economic growth: The third macroeconomic objective is to increase the output of the nation’s goods and services year after year. Economic growth refers to the increase in real Gross Domestic Product (GDP) and can be measured by finding the total value of a nation’s output one year, comparing it to the previous year, and adjusting it for any changes in the price level between the years. Economic growth is a desirable goal because it generally means that incomes are rising and people’s lives are getting better. Of course, GDP only measures the physical output of goods and services, and does not include many non-economic variables that also should be considered when measuring people’s well-being. But rising incomes and output are deemed worthy goals since they are associated with rising living standards.

Assignment: Complete the readings and online activities above. Then use the data in the table linked below to answer the quesitons that follow.


Questions:

  1. Calculate the unemployment rates for each of the years in the table. Describe what happened to unemployment over the years displayed.
  2. Calculate the inflation rates between each of the years in the table. Describe what happened to inflation over the years displayed.
  3. Calculate the Real GDP for each of the years in the table.
  4. Calculate the Real GDP growth rates between each of the years in the table. Describe what happened to real GDP from one year to the next in the years displayed.
  5. Describe the relationship between the inflation and unemployment rates you calculated for each of the years. Is there any correlation in how the figures change from year to year?
  6. Based on your analysis of the data above, to what extent has the United States succeeded in achieving its three macroeconomic objectives of:

7 responses so far

Sep 30 2011

Lesson Plan: Macroeconomic Indicators around the World

Directions: Macroeconomics is an area of study with precise goals attached to it. Macroeconomists generally agree that there are three primary goals towards which policies should be used to try and achieve:

Understanding the indicators used in macroeconomics to measure the success in these three areas is important. In the activity that follows, you will research, define, and explain the various types of inflation, unemployment and economic growth. You will also research and record examples of these indicators from several countries. Finally, you will investigate your OWN country, and determine what precisely makes up the total amount of economic activity in your country.

 

Part 1: Using your notes and your textbook (Welker’s chapters 11, 12, 13, 14 and 15), answer the following questions. Most of the country data you are asked to find can be found in the CIA World Factbook.

Define and explain the various types of each of the following:

  1. Define inflation [2 marks]
    1. Type 1 [1 mark]:
    2. Type 2 [1 mark]:
    3. Research and identify the current inflation rates in [3 marks]:
      • Switzerland
      • China
      • United States
  2. Define unemployment [2 marks]
    1. Type 1 [1 mark]:
    2. Type 2 [1 mark]:
    3. Type 3 [1 mark]:
    4. Research and identify the current unemployment rates in [3 marks]:
      • The UK
      • Germany
      • Spain
  3. Define Full Employment and Natural Rate of Unemployment [2 marks]
  4. Define economic growth and illustrate the concept of growth using a production possibilities curve [4 marks]
    1. Research and identify the most recent GDP growth rates in
      • Nigeria
      • Greece
      • Japan

Part 2:

  1. Identify the four components of a nation’s aggregate demand and briefly explain two factors that affect each of the four components (this can be found in Welker’s chapter 12) [10 marks]
  2. Research and identify the main macroeconomic indicators for your home country. Enter the information you find into THIS ONLINE FORM, and click submit when you’re done.

Part 3: The Results : You can view the results of the form by clicking HERE

Discussion Questions:

  1. Which of the countries appear to be doing the BEST job of meeting their macroeconomic objectives of low unemployment, low inflation and economic growth?
  2. Which countries appear to be doing the WORST at meeting their macroeconomic objectives?
  3. Which countries have the highest GDP growth rates? What do the highest growth countries have in common? What is different about them?
  4. Which countries have the lowest unemployment rates? What do these countries have in common?
  5. Which country experienced a recession in 2010? Discuss the possible relationship between economic growth and unemployment?

5 responses so far

Aug 16 2011

Too much debt or not enough demand? A summary of the debate over America’s fiscal future

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30′s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

  • Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
  • This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
  • Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
  • The really scary thing is the prospect of another Great Depression.
  • Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
  • With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
  • Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
  • If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
  • We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
  • The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
  • The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
  • Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
  • When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

  • The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
  • There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
  • This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
  • If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
  • This is not a double dip recession, because we never left the first one.
  • Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
  • If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
  • Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
  • Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
  • Until we get the debt levels down, we cannot get back to robust growth.
  • It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
  • When it comes down to it, there is just too much debt in the economy!

Discussion Question:

  1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
  2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
  3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
  4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
  5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

19 responses so far

May 05 2010

Facts and the Phillips Curve: new evidence of the short-run trade-off between unemployment and inflation

Introduction: The following is a selection of a chapter from my new Economics textbook project, the Pearson Baccalaureate Economics text, which will be available to IB Economics teacher for the 2011-2013 school year.

It should be noted that the original Phillips Curve theory did not distinguish between the short-run and the long-run. In fact, the original Phillips Curve itself was a long-run model demonstrating a trade-off between unemployment and changes in the wage rate over a span of 52 years in the United Kingdom.

Up until the early 1970s, the Phillips Curve was treated as a generally accurate demonstration of the relationship between two important macroeconomic indicators. Throughout the 60′s data for the United States showed in most cases that increases in unemployment corresponded with lower inflation rates, and vis versa.

Year 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969
UR 5.5 6.7 5.5 5.7 5.3 4.5 3.8 3.6 3.5 3.7
IR 1.46 1.07 1.2 1.24 1.28 1.59 3.01 2.78 4.27 5.46

As can be seen above, between almost every year of the decade a fall in the inflation rate corresponded with a rise in unemployment. The only exceptions were between 1962 and 1963, when both unemployment and inflation increased slightly, and between 1968 and 1969, when again both variables increased. Phillips’ theory of the trade-off between unemployment and inflation was generally supported throughout most of the decade, as the downward slope of the line in the graph above demonstrates.

Beginning in 1970, however, data for the US began to point to a flaw in the Phillips curve theory. Throughout the decade, both unemployment and inflation rose in the US, as oil exporters in the Middle Ease, united under the Oil Producing and Exporting Countries (OPEC) cartel, placed embargoes on oil exports to the US in retaliation for America’s support of Israel in a war against its Arab neighbors. The resulting supply shock in the US led to energy and petrol shortages and rising costs for US firms, forcing businesses to reduce costs by laying off workers, while simultaneously raising output prices. Several other macroeconomic variables contributed to rising unemployment and inflation in the late 1970s, including the return of tens of thousands of troops from the Vietnam War who entered the labor market and found themselves unemployed as firms reduced output in the face of rising energy costs. The Phillips Curve for the 1970s told a somewhat different story about inflation and unemployment than that of the 1960s.

Year 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
UR 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.1 6.1 5.8
IR 5.84 4.3 3.27 6.16 11.03 9.2 5.75 6.5 7.62 11.22

Between 1973 and 1974, both the unemployment rate and the inflation rate increased significantly, and even as unemployment increased by almost 3% between 1974 and 1975, the inflation rate fell by less than 2% but still remained at nearly 10%. Unlike the 1960s, the 1970s was a decade of both high unemployment AND high inflation. By the end of the decade, unemployment was at approximately the same level as it was in 1963 (5.8%) but inflation was nearly 10 times higher (11.22% in 1979 versus just 1.24% in 1963). The Phillips Curve theory was apparently busted, as the seemingly random scattering of data in the graph above points to no discernible trade-off between unemployment and inflation throughout the 1970s.

Several prominent economists in the 1970s, including Nobel Laureate Milton Friedman, revived the classical view of the macroeconomy which held that policies aimed at managing aggregate demand would ultimately be unsuccessful at decreasing unemployment in the long-run, since a nation’s output and employment would always return to the full-employment level regardless of the level of demand in the economy. Friedman, whose theory of the macroeconomy would come to be known as monetarism, believed that changes in the money supply would lead to inflation or deflation, but no change in unemployment in the long-run. Monetary policy and its effects on aggregate demand and aggregate supply will be explored in more depth in a later chapter in this book. The basic premise of the monetarists, however, was that in order to maintain stable prices and low unemployment, the nation’s money supply should be allowed to grow at a steady rate, corresponding with the desired level of economic growth. Any increase in the money supply aimed at stimulating spending and aggregate demand would result in an increase in inflationary expectations, an increase in nominal wages, and a leftward shift of aggregate supply, resulting only in higher inflation and no change in real output and employment. Therefore, monetary rules were needed to assure that policymakers would not manipulate the supply of money to try and stimulate or contract the level of aggregate demand in the economy.

By the late 1970s, our current interpretation of the Phillips’ theory as including both a short-run and a long-run model became widely adopted. The short-run Phillips Curve may accurately illustrate the trade-off between unemployment and inflation observed in the period of time over which wages and prices are relatively inflexible in a nation’s economy. For instance, during the twelve month period between July 2008 and June 2009, the level of consumption and investment in the US fell as the economy slipped into recession. Unemployment rose and inflation decreased and eventually became negative in the final three months of the period. The graph below shows the relationship between unemployment and inflation during the onset of the recession in 2008 and 2009.

A clear trade-off appears to have existed in the twelve month period above. At the time of writing, it is yet to be seen whether the unemployment rate will return to its pre-recession level in the United States. Although in the short-run it seems likely that the downward sloping Phillips Curve holds some truth, a look at a longer period of time for the same country tells a different story. The graph below shows the unemployment / inflation relationship during the twelve years leading up to the onset of recession in 2008.

Looking at data for a longer period of time shows that even as inflation fluctuated between 0.5% and 4%, US unemployment remained in a relatively narrow range of between 4% and 6%. Year on year unemployment and inflation often increased together, while at other times demonstrated an inverse relationship as Phillips’ theory predicts it should. The narrow range of unemployment portrayed in the data above is evidence that the Long-run Phillips curve for the US between 1997 and 1998 was more like a vertical line than a downward sloping one. It appears that during the period above the natural rate of unemployment for the United States was around 5%; meaning that even as AD increased and decreased in the short-run, the level unemployment remained relatively steady around the natural rate of 5% in the long-run.

The 1970′s represented a turning point in the mainstream economic analysis of the relationship between inflation and unemployment. Demand-management policies by governments may be effective at fine-tuning an economy’s employment level and price level in the short-run, but as data from the 1970′s and early 2000s shows, in the long-run a nation’s level of unemployment tends to be independent of the inflation rate, and is likely to remain around the natural rate of unemployment once wages and prices have adjusted to fluctuations in aggregate demand. In response to supply shocks such as the oil shortages of the 1970′s, both inflation and unemployment may increase at the same time, calling into question the validity of the original Phillips Curve relationship. Despite the breakdown in the relationship between unemployment and inflation in the long-run, the evidence from the recession of 2008 and 2009 seems to support the theory that an economy in which aggregate demand is falling will experience a short-run trade-off between the rate of inflation and the rate of unemployment.

11 responses so far

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