Economics: The Matchup of the Century - Unemployment vs. Inflation

One of the ten main principles of economics is that society faces a short run trade off between unemployment and inflation. In other words, society has to have one or the other no matter what in the short run.

Here, we define the Phillips Curve, a downward sloping curve with inflation rate on the y-axis and unemployment on the x-axis. There is a negative correlation between inflation and unemployment.

We can explain the Phillips curve using the AG demand and shot run AG supply graph. When AG demand is high, the equilibrium is at a higher output and thus lower unemployment. However, the equilibrium is at a higher price level (aka more inflation). The opposite holds true for the converse.

In the long run, the Phillips Curve is actually vertical. Classical theory states nominal changes like inflation do not affect real variables like output and unemployment. This line is located at the natural rate of unemployment. This curve also shows how monetary policies do not affect unemployment in the long run, no matter what the Fed does.

The meaning of "natural" in the natural rate of unemployment is where the economy gravitates to in the long run. This does not mean it is socially desirable, it is just spontaneous. Government policies like removing unions would then be able to shift this vertical line, in this example it would move left (less unemployment with no unions since lower wages).

Unemployment rate = Natural rate of unemployment - a (actual inflation - expected inflation)
where the variable 'a' measures how unemployment responds to unexpected inflation.

Using the above equation, we can put together the short run and long run Phillips curves. Inflation and unemployment starts at the intersection of both. When inflation rises, in the short run the equilibrium moves off the long run curve and moves along the short run Phillips curve to a point with less unemployment. Then as people expect higher inflation, the short run Phillips curve shifts right so that at the same inflation rate the two curves once more intersect.

If a supply shock happens (i.e. a shift of AG short run supply curve), the Phillips curve shifts. In the case of a negative supply shock, the Phillips curve shifts rightward, giving policymakers a worse deal between unemployment and inflation.

To reduce inflation, it comes with a cost. According to the Sacrifice Ratio, and the graph with both long run and short run Phillips curves, reducing inflation temporarily increases unemployment until in the long run inflation is reduced and output returns back to normal. The estimated sacrifice ratio is 5, i.e. 5% annual output must be sacrificed for every reduction of 1% in inflation.

Another theory disagrees. According to other economists, there is something called rational expectations. If the government makes it clear to the people that they will reduce inflation and people believe, their expectations of inflation will reduce, immediately shifting the short run Phillips Curve to put inflation lower without having to increase unemployment temporarily.

Unemployment and inflation managed to be both very low in the 1990s in the U.S. because of declining commodity prices (like the fall of OPEC, recessions in Asian countries, etc. leading to a favorable supply shock), labor-market changes (the baby-boom is theorized to reduce the natural rate of unemployment since older people tend to hold stabler jobs), and technological advance (favorable supply shock).