Page 756 - The Principle of Economics

776 PART TWELVE
SHORT-RUN ECONOMIC FLUCTUATIONS
This shift in aggregate supply is associated with a similar shift in the short-run Phillips curve, shown in panel (b). Because firms need fewer workers to produce the smaller output, employment falls and unemployment rises. Because the price level is higher, the inflation rate—the percentage change in the price level from the previous year—is also higher. Thus, the shift in aggregate supply leads to higher unemployment and higher inflation. The short-run tradeoff between inflation and unemployment shifts to the right from PC1 to PC2.
Confronted with an adverse shift in aggregate supply, policymakers face a dif- ficult choice between fighting inflation and fighting unemployment. If they con- tract aggregate demand to fight inflation, they will raise unemployment further. If they expand aggregate demand to fight unemployment, they will raise inflation further. In other words, policymakers face a less favorable tradeoff between infla- tion and unemployment than they did before the shift in aggregate supply: They have to live with a higher rate of inflation for a given rate of unemployment, a higher rate of unemployment for a given rate of inflation, or some combination of higher unemployment and higher inflation.
An important question is whether this adverse shift in the Phillips curve is temporary or permanent. The answer depends on how people adjust their expec- tations of inflation. If people view the rise in inflation due to the supply shock as a temporary aberration, expected inflation does not change, and the Phillips curve will soon revert to its former position. But if people believe the shock will lead to a new era of higher inflation, then expected inflation rises, and the Phillips curve remains at its new, less desirable position.
In the United States during the 1970s, expected inflation did rise substantially. This rise in expected inflation is partly attributable to the decision of the Fed to
“Remember the good old days when all the economy needed was a little fine-tuning?”