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

Wrap-Up
INFLATION AND CYCLICAL UNEMPLOYMENT
The natural rate of unemployment is the unemployment rate when the economy is at
potential GDP and cyclical unemployment is zero.
The short-run inflation adjustment (SRIA) curve shows the rate of inflation at each
level of output relative to potential GDP, for a given expected rate of inflation.
The SRIA curve has a positive slope. If output increases above potential, inflation
increases. If output falls below potential, inflation falls.
THE ROLE OF EXPECTATIONS: SHIFTS IN THE
SHORT-RUN INFLATION ADJUSTMENT CURVE
Figure 37.4 illustrated a second characteristic of the relationship between unemployment
and inflation—the relationship does not seem to be stable. It has shifted
over time. Though the relationship between cyclical unemployment and inflation
was stable in the 1960s, that stability disappeared in the 1970s. The U.S. economy experienced
high unemployment and high inflation. Stagflation was the term coined to
describe this undesirable situation. High inflation occurred while output was below
potential. At other times, output was above potential, yet inflation was low. The
SRIA curve is not stable.
There is a simple explanation for this instability: the level of cyclical unemployment
is not the only factor that affects wages. For one thing, expectations of inflation
also matter. Take the case of a union contract. If workers and firms expect that inflation
will be 3 percent per year over the life of the contract, then the nominal wage called
for in the contract will rise 3 percent per year even if the negotiated real wage remains
constant. Employers are willing to let the nominal wage increase, because they
believe they will be able to sell what they produce at higher prices.
If unemployment is low and people are expecting inflation, wages may rise even
faster than is necessary simply to offset expected inflation. When unemployment
is low and output above potential, workers enjoy better job prospects and are more
likely to quit to take better jobs, while firms will find it harder to hire replacements.
Wages will rise faster as firms try both to prevent their existing workers from leaving
and to attract new workers. If an inflation rate of 3 percent is expected, nominal
wages might rise at 5 percent per year (3 percent to compensate for increases in
the cost of living and 2 percent because labor markets are tight). If workers and
firms expect a much higher rate of inflation, say, 10 percent, then low unemployment
may lead money wages to rise at 12 percent per year (10 percent to compensate for
the rising cost of living, plus 2 percent because labor markets are tight).
Because expectations of inflation affect actual inflation, the SRIA curve shows the
relationship between output (relative to potential) and inflation, for a given expected
rate of inflation. This is represented diagrammatically in Figure 37.6. A vertical line
is drawn at the level of full-employment output Y f to indicate that Y f does not depend
824 ∂ CHAPTER 37 INFLATION AND UNEMPLOYMENT