Page 745 - The Principle of Economics

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 765
In panel (b) of the figure, we can see what these two possible outcomes mean for unemployment and inflation. Because firms need more workers when they produce a greater output of goods and services, unemployment is lower in out- come B than in outcome A. In this example, when output rises from 7,500 to 8,000, unemployment falls from 7 percent to 4 percent. Moreover, because the price level is higher at outcome B than at outcome A, the inflation rate (the percentage change in the price level from the previous year) is also higher. In particular, since the price level was 100 in year 2000, outcome A has an inflation rate of 2 percent, and outcome B has an inflation rate of 6 percent. Thus, we can compare the two possi- ble outcomes for the economy either in terms of output and the price level (using the model of aggregate demand and aggregate supply) or in terms of unemploy- ment and inflation (using the Phillips curve).
As we saw in the preceding chapter, monetary and fiscal policy can shift the aggregate-demand curve. Therefore, monetary and fiscal policy can move the economy along the Phillips curve. Increases in the money supply, increases in government spending, or cuts in taxes expand aggregate demand and move the economy to a point on the Phillips curve with lower unemployment and higher inflation. Decreases in the money supply, cuts in government spending, or in- creases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment. In this sense, the Phillips curve offers policymakers a menu of combinations of inflation and unemployment.
QUICK QUIZ: Draw the Phillips curve. Use the model of aggregate demand and aggregate supply to show how policy can move the economy from a point on this curve with high inflation to a point with low inflation.
SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS
The Phillips curve seems to offer policymakers a menu of possible inflation- unemployment outcomes. But does this menu remain stable over time? Is the Phillips curve a relationship on which policymakers can rely? Economists took up these questions in the late 1960s, shortly after Samuelson and Solow had intro- duced the Phillips curve into the macroeconomic policy debate.
THE LONG-RUN PHILLIPS CURVE
In 1968 economist Milton Friedman published a paper in the American Economic Review, based on an address he had recently given as president of the American Economic Association. The paper, titled “The Role of Monetary Policy,” contained sections on “What Monetary Policy Can Do” and “What Monetary Policy Cannot Do.” Friedman argued that one thing monetary policy cannot do, other than for only a short time, is pick a combination of inflation and unemployment on the Phillips curve. At about the same time, another economist, Edmund Phelps, also