David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

22.4 Inflation, unemployment and output
Combining equations (1) and (2):
1t = 0.02 - (a + b)(U- U*) (3)
In this example, when unemployment has reverted to its long-run equilibrium, inflation is then 2 per cent. In
the short run, inflation is affected by deviations of unemployment from equilibrium unemployment not only
because this affects wages, prices and inflation, but also because it has a second effect on inflation expectations
themselves. Exactly how inflation expectations adjust over time in the real world is a subject of continuing
controversy.
Figure 22.7 shows an adverse temporary supply shock. The short-run Phillips curve shifts up, from PC1 to
PC2• If monetary policy accommodates the shock, the target inflation rate rises from 7t1 to 7t2. The economy
moves from E to Fwith no change in output or unemployment, but at the cost of higher inflation. Eventually
the shock wears off, since it is temporary, and the economy reverts to E, with another accommodating
change in monetary policy.
Alternatively, monetary policy may not fully accommodate the supply shock. In
Chapter 21, we showed that this would mean higher inflation and lower output.
Now, the analogue is higher inflation and higher unemployment - stagflation. To
prevent inflation shifting up by as much as the vertical shift up in the short-run
Phillips curve, monetary policy makes sure that aggregate demand falls a bit.
Hence inflation rises a bit and unemployment rises a bit. The economy moves
from E to Gin Figure 22.7. Output stagnates despite higher inflation.
Stagflation is high inflation
and high unemployment,
caused by an adverse supply
shock.
Again, the credibility of policy is crucial. If workers
think the government, frightened of high unemployment,
will accommodate any shock, large wage rises
buy temporarily higher real wages until prices adjust
fully. And in the long run, monetary policy is loosened
to maintain aggregate demand at full employment, so
there is little danger of extra unemployment.
Q)
..
0
7t
PC2
LRPC
Once a government proves that it will not accommodate
shocks, nominal wage growth slows. Workers then fear
that higher wages will reduce demand and price workers
out of a job.
c
0
·=
0
;::
c
1t2
1t1
Fifty years of inflation and unemployment
The original Phillips curve seemed to offer a permanent
trade-off between inflation and unemployment. It also
suggested both inflation and unemployment could be
low.
At that time, governments were committed to full
employment even in the short run. Any shock tending
to raise inflation - including temporary supply shocks -
was accommodated by a higher money supply to prevent
a fall in aggregate demand. Money growth and inflation
steadily rose. After the mid-l 970s, government policy
changed in most countries. The emphasis was on keeping
U*
Unemployment rate
An adverse but temporary supply shock shifts PC1 to PC2
without affecting LRPC. Beginning from E monetary polic:
can accommodate the shock, moving to F. If interest rate
are raised to prevent inflation rising as high as 7t2, the fa
in demand raises unemployment. At G the economy
experiences stagflation, both high inflation and high
unemployment.
Figure 22.7 Temporary supply shocks
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