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

Review and Practice
SUMMARY
1. Other things being equal, in the short run, higher unemployment
is associated with lower inflation. This
relationship is called the Phillips curve.
2. Other things being equal, lower output is associated with
lower inflation. This relationship is called the short-run
inflation adjustment (SRIA) curve.
3. The level of inflation associated with any particular level
of cyclical unemployment or output gap will increase as
expectations of inflation increase. As a result, if the government
attempts to maintain unemployment at too low
a rate, the inflation rate will continually increase, as each
increase in inflation is built into individuals’ expectations.
The expectations-augmented inflation adjustment
curve reflects the effects of inflationary expectations.
4. The unemployment rate at which inflation is stable—at
which actual inflation is equal to expected inflation—is
called the natural rate of unemployment. Saying that
inflation is stable when the output gap is zero expresses
the same idea.
5. The natural rate of unemployment can change because of
changes in the structure of the labor force or increasing
competition in labor and product markets.
6. Inflation shocks such as oil price fluctuations will affect
inflation, for given levels of output and inflationary
expectations. A sharp rise in oil prices, for example,
shifts the SRIA curve up.
KEY TERMS
Phillips curve
natural rate of unemployment
short-run inflation adjustment (SRIA) curve
adaptive expectations
inflation shocks
REVIEW QUESTIONS
1. Why is there a trade-off between cyclical unemployment
and inflation in the short run?
2. What role do changes in expectations play in shifting the
SRIA curve? What difference does it make whether
expectations are adaptive or rational?
3. Why, if unemployment is kept below its natural rate, will
the rate of inflation rise? What is the long-run trade-off
between unemployment and inflation?
4. What factors affect the natural rate of unemployment?
5. What is an example of an inflation shock? How does a
positive inflation shock affect the inflation adjustment
curve?
PROBLEMS
1. Jennifer earns $40,000 per year, but her wages are not
indexed to inflation. If over a period of three years inflation
is at 5 percent and Jennifer receives raises of 2 percent
every year, how much has the actual buying power
of her income changed over that time?
2. What would be the effect on the short-run inflation
adjustment curve of an announcement that OPEC—
the cartel of oil-producing countries—had fallen
apart, and thus the price of oil was expected to fall
dramatically?
3. While playing around with old economic data in your
spare time, you find that in 1963 the unemployment rate
was 5.7 percent and the inflation rate was 1.6 percent; in
1972, the unemployment rate was 5.6 percent and the
inflation rate was 3.4 percent; in 1979, unemployment
was 5.8 percent and inflation was 13.3 percent; in 1988,
unemployment was 5.5 percent and inflation was 4.4
percent; in 1996, unemployment was 5.4 percent and
inflation was 3.3 percent. Does this evidence necessarily
imply anything about the shape of the SRIA curve? How
might you interpret these data?
4. A simple form of adaptive expectations has expectations
equal to inflation in the previous year. If inflation in year
t is written as π t , then expected inflation in year t would
be π t−1 . Suppose we write the Phillips curve relationship
between unemployment and inflation as
π t =π t−1 − .5 × (U t − U * ),
where U t is the unemployment rate for year t and U * is
the natural rate. Assume U * = 5 percent. Suppose initially
in year 1 the inflation rate is 4 percent per year and the
834 ∂ CHAPTER 37 INFLATION AND UNEMPLOYMENT