Page 750 - The Principle of Economics

770 PART TWELVE
SHORT-RUN ECONOMIC FLUCTUATIONS
Friedman and Phelps were well aware of these questions, and they offered a way to reconcile classical macroeconomic theory with the finding of a down- ward-sloping Phillips curve in data from the United Kingdom and the United States. They claimed that a negative relationship between inflation and unem- ployment holds in the short run but that it cannot be used by policymakers in the long run. In other words, policymakers can pursue expansionary monetary policy to achieve lower unemployment for a while, but eventually unemployment re- turns to its natural rate, and more expansionary monetary policy leads only to higher inflation.
Friedman and Phelps reasoned as we did in Chapter 31 when we explained the difference between the short-run and long-run aggregate-supply curves. (In fact, the discussion in that chapter drew heavily on the legacy of Friedman and Phelps.) As you may recall, the short-run aggregate-supply curve is upward sloping, indicating that an increase in the price level raises the quantity of goods and services that firms supply. By contrast, the long-run aggregate-supply curve is vertical, indicating that the price level does not influence quantity supplied in the long run. Chapter 31 presented three theories to explain the upward slope of the short-run aggregate-supply curve: misperceptions about relative prices, sticky wages, and sticky prices. Because perceptions, wages, and prices adjust to changing economic conditions over time, the positive relationship between the price level and quantity supplied applies in the short run but not in the long run. Friedman and Phelps applied this same logic to the Phillips curve. Just as the aggregate-supply curve slopes upward only in the short run, the tradeoff between inflation and unemployment holds only in the short run. And just as the long-run aggregate-supply curve is vertical, the long-run Phillips curve is also vertical.
To help explain the short-run and long-run relationship between inflation and unemployment, Friedman and Phelps introduced a new variable into the analysis: expected inflation. Expected inflation measures how much people expect the overall price level to change. As we discussed in Chapter 31, the expected price level af- fects the perceptions of relative prices that people form and the wages and prices that they set. As a result, expected inflation is one factor that determines the posi- tion of the short-run aggregate-supply curve. In the short run, the Fed can take ex- pected inflation (and thus the short-run aggregate-supply curve) as already determined. When the money supply changes, the aggregate-demand curve shifts, and the economy moves along a given short-run aggregate-supply curve. In the short run, therefore, monetary changes lead to unexpected fluctuations in output, prices, unemployment, and inflation. In this way, Friedman and Phelps explained the Phillips curve that Phillips, Samuelson, and Solow had documented.
Yet the Fed’s ability to create unexpected inflation by increasing the money supply exists only in the short run. In the long run, people come to expect what- ever inflation rate the Fed chooses to produce. Because perceptions, wages, and prices will eventually adjust to the inflation rate, the long-run aggregate-supply curve is vertical. In this case, changes in aggregate demand, such as those due to changes in the money supply, do not affect the economy’s output of goods and services. Thus, Friedman and Phelps concluded that unemployment returns to its natural rate in the long run.
The analysis of Friedman and Phelps can be summarized in the following equation (which is, in essence, another expression of the aggregate-supply equa- tion we saw in Chapter 31):