In this note we looked more deeply into issues related to inflation and unemployment. We defined these concepts and looked into what is good and bad about them. We find that most countries are willing to tolerate at least a modicum of both inflation and unemployment. With respect to inflation we worry that the cost of getting rid of it might be worse than tolerating a small amount of it. The same conclusion holds for unemployment plus we add the complication that means to reduce NAIRU seem at least confusing if not uncertain.
We showed that aggregate demand shocks and policies create tradeoffs with respect to inflation and unemployment. The negative slope of the Phillips Curve vividly depicts these tradeoffs and explains why one cannot eliminate one of these problems without exacerbating the other. Yet, aggregate supply shocks and policies offer an escape from these onerous tradeoffs. Aggregate supply shocks and/or policies can move the Phillips Curve in an inward (left) direction, causing improvements in both inflation and unemployment. A checkered past, uncertain outcomes, and sensitive political problems, however, make it difficult for leaders to forcefully advocate these policies.
An interesting short article in the Financial Times appeared on February 4, 2005 (page 3), “Figures point to pressure for new US jobs,” by Christopher Swann and Andrew Balls. The column was written because US productivity data for the fourth quarter of 2004 was announced and revealed a slowdown in that quarter – with productivity rising at a 0.8% annualized rate in that quarter. Productivity for the whole year had increased by 4.1%. Thus, the authors felt this would create some uncertainty for the Fed. If productivity in 2005 would grow at 4.1%, the Fed could easily forget about inflation problems and would not need to increase interest rates. The authors also noted that there remained in the fourth quarter plenty of slack in labor markets (the unemployment rate above NAIRU), and this boded well for inflation. But if the fourth quarter was a good indication of a significant slowdown in productivity in 2005, then costs might continue rising faster than productivity (implying an undesirable shift in the Phillips Curve) and the Fed would need to be more concerned about future inflation and unemployment.