Page 378 - Krugmans Economics for AP Text Book_Neat

figure 34.5

The NAIRU and the Long - Run Inflation
rate
Phillips Curve
8% Long-run Phillips
SRPC 0 is the short - run Phillips curve when the expected infla- curve, LRPC
tion rate is 0%. At a 4% unemployment rate, the economy is at 7
point A with an actual inflation rate of 2%. The higher inflation 6 C
rate will be incorporated into expectations, and the SRPC will
5
shift upward to SRPC 2 . If policy makers act to keep the unem- B
ployment rate at 4%, the economy will be at B and the actual in- 4 E 4
flation rate will rise to 4%. Inflationary expectations will be 3
revised upward again, and SRPC will shift to SRPC 4 . At a 4% un- A E 2
2 SRPC
employment rate, the economy will be at C and the actual infla- 4
tion rate will rise to 6%. Here, an unemployment rate of 6% is 1
E SRPC
the NAIRU, or nonaccelerating inflation rate of unemployment. 0 2
0
As long as unemployment is at the NAIRU, the actual inflation 3 4 5 6 7 8%
–1
rate will match expectations and remain constant. An unemploy- Nonaccelerating inflation
ment rate below 6% requires ever - accelerating inflation. The –2 rate of unemployment, NAIRU SRPC 0
long - run Phillips curve, LRPC, which passes through E 0 , E 2 , and
–3
E 4 , is vertical: no long - run trade - off between unemployment and Unemployment rate
inflation exists.

Eventually, the 4% actual inflation rate gets built into expectations about the fu-
The nonaccelerating inflation rate of
ture inflation rate, and the short - run Phillips curve shifts upward yet again to
unemployment, or NAIRU, is the
SRPC 4 . To keep the unemployment rate at 4% would now require accepting a 6% ac-
unemployment rate at which inflation does
tual inflation rate, point C on SRPC 4 , and so on. In short, a persistent attempt to
not change over time.
trade off lower unemployment for higher inflation leads to accelerating inflation
The long -run Phillips curve shows the
over time.
relationship between unemployment and
To avoid accelerating inflation over time, the unemployment rate must be high enough that
inflation after expectations of inflation have
had time to adjust to experience. the actual rate of inflation matches the expected rate of inflation. This is the situation at E 0
on SRPC 0 : when the expected inflation rate is 0% and the unemployment rate is 6%,
the actual inflation rate is 0%. It is also the situation at E 2 on SRPC 2 : when the ex-
pected inflation rate is 2% and the unemployment rate is 6%, the actual inflation rate
is 2%. And it is the situation at E 4 on SRPC 4 : when the expected
inflation rate is 4% and the unemployment rate is 6%, the ac-
tual inflation rate is 4%. As we’ll learn shortly, this relationship
between accelerating inflation and the unemployment rate is
known as the natural rate hypothesis.
The unemployment rate at which inflation does not change
over time—6% in Figure 34.5—is known as the nonaccelerating
inflation rate of unemployment, or NAIRU for short. Keeping
the unemployment rate below the NAIRU leads to ever -
Andy sacks/Stone Getty Images economists believe that there is a NAIRU and that there is no
accelerating inflation and cannot be maintained. Most macro-

long - run trade - off between unemployment and inflation.
We can now explain the significance of the vertical line LRPC.
It is the long - run Phillips curve, the relationship between un-
employment and inflation in the long run, after expectations of
The non-accelerating inflation rate of un- inflation have had time to adjust to experience. It is vertical be-
employment, or NAIRU, is the unemploy-
ment rate at which inflation does not cause any unemployment rate below the NAIRU leads to ever - accelerating inflation. In
change over time. other words, the long-run Phillips curve shows that there are limits to expansionary
policies because an unemployment rate below the NAIRU cannot be maintained in the
long run. Moreover there is a corresponding point we have not yet emphasized: any un-
employment rate above the NAIRU leads to decelerating inflation.

336 section 6 Inflation, Unemployment, and Stabilization Policies