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

the oil embargo imposed by the Organization of Petroleum Exporting Countries
(OPEC) as a result of the 1973 Arab-Israeli War. The sharp increases in inflation
caused by these oil price increases are clearly visible in Figure 37.1. As this experience
suggests, other factors besides cyclical unemployment and expectations
influence inflation.
The basic relationship between output and inflation that we summarized in
the inflation adjustment curve started with the Phillips curve relationship between
cyclical unemployment and wage increases. We then argued that wages and
prices move in tandem, and thus the SRIA curve links cyclical unemployment
and inflation. While Figure 37.3 shows that wages and prices generally move
together, it also shows that inflation exceeded wage increases at the time of the
oil price shocks. The oil price changes altered the relationship between wages
and prices.
The reason is straightforward. Wages are a large part of the costs that firms face.
But firms have other important costs as well, and the cost of the energy involved
in producing is one of them. For a given increase in wages, prices will rise more
as these other costs rise. The oil price hikes of the 1970s increased inflation
relative to wages, as shown in Figure 37.3. Such events are called inflation
shocks, and they produce temporary shifts in the SRIA curve. For given inflation
expectations and output, a positive inflation shock increases the actual rate
of inflation.
Some economists have argued that the late 1990s were a repeat of the 1970s but
in reverse. That is, the United States was again hit by an inflation shock—but this
time, a negative shock that temporarily shifted the SRIA curve down. Inflation was
lower at each level of output. Put another way, we can say that inflation was lower
at each level of cyclical unemployment. Two pieces of evidence are consistent with
this interpretation. First, if we again look back to Figure 37.3, we see that just as
inflation was pushed above the rate of wage increases by the positive inflation shocks
of the 1970s, so during the 1990s inflation fell below wage increases. Second, at the
end of the 1990s, unemployment plummeted. In April 2000, for example, the overall
jobless rate fell to 3.9 percent, the lowest level since 1970. Despite this evidence
of tight labor markets, inflation had not increased, as the SRIA curve would imply
should happen. This stability, too, might indicate that the economy was experiencing
a negative inflation shock.
Fundamentals of Inflation
CYCLICAL UNEMPLOYMENT
Movements in cyclical unemployment cause fluctuations in the rate of wage growth
relative to productivity growth. In tight labor markets, wages will rise more rapidly;
in periods of high unemployment, wage growth will slow and wages may decline.
These fluctuations in firms’ wage costs are passed through into prices and lead to
fluctuations in the rate of inflation. As a consequence, fluctuations in the output gap
will be positively associated with fluctuations in the rate of inflation.
SHORT-RUN INFLATION ADJUSTMENT ∂ 831