[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

full-employment model shows that once real wages have adjusted, the economy will
be at full employment, no matter what the rate of inflation might be.
In Chapter 31 we assumed that inflation rises and falls as the economy moves
above or below potential GDP. The adjustment of inflation played a critical role in eventually
moving the economy to full employment. In this chapter, we will examine the
foundations of inflation adjustment in more detail. Three factors are important for
explaining how inflation varies over time. First, while wages do not adjust quickly to
keep demand equal to supply, they do respond over time whenever demand does
not equal supply. Increases in cyclical unemployment lead to lower inflation; decreases
in cyclical unemployment lead to higher inflation. Second, wages and prices depend
on workers’ and firms’ expectations about inflation. For example, if workers expect
prices to rise faster, they will demand higher wage increases. An increase in expected
inflation leads to an increase in actual inflation. Third, economies occasionally experience
inflation shocks—increases in costs such as the dramatic rise in oil prices of
the 1970s. We will see that increases in inflation expectations or inflation shocks
that boost actual inflation force policymakers to make difficult trade-offs.
Short-Run Inflation Adjustment
The framework for thinking about how demand and supply pressures influence the
rate of change of wages is summarized in a famous relationship called the Phillips
30
25
20
INFLATION RATE (%)
15
10
5
France
United Kingdom
0
United States
Japan
–5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Figure 37.1
INFLATION AMONG THE
MAJOR INDUSTRIALIZED
ECONOMIES
The general pattern of inflation in the United States, Japan, the United Kingdom (U.K.),
and France during the past forty years has been quite similar. Average inflation rose
dramatically in the early 1970s, rose again in the late 1970s, and declined in the
early 1980s.
SOURCE: International Financial Statistics (2005).
820 ∂ CHAPTER 37 INFLATION AND UNEMPLOYMENT