There are many controversial issues in macroeconomics, and one of them is the trade-off between inflation and unemployment. That is the issue that this blog addresses.
Accelerationists are economists who argue that there is no long-run trade-off between inflation and unemployment. For them, the long-run Phillips curve is vertical. The following diagram will help to explain the accelerationists’ point of view.
Let us suppose that the natural rate of unemployment is 7% as shown in the diagram, but policy-makers attempt to reduce it to 4%, believing that 4% constitutes full employment. The policy-makers will use monetary and fiscal policies to increase aggregate demand. Because the economy is already at its natural rate of unemployment, the increase in aggregate demand will cause the price level to rise. If nominal wages remain constant, then the increase in prices raises the profit margins of firms. Higher profits cause businesses to expand, hire more workers, and thus reduce the rate of unemployment from 7% to 4%. The economy thus moves from A to B along the short-run Phillips curve PC1. The rate of inflation has risen from 0% to 3% at B. Policy-makers have chosen to live with a 3% inflation rate in order to achieve a 4% unemployment rate.
According to the accelerationists, however, the economy will not remain at B for long. That position is only transitory. Now that the rate of inflation has risen to 3%, workers adjust their expectations of inflation and demand higher wages to compensate for the loss in real wages caused by the increase in the price level. The higher wages reduce the firms’ profits and cause them to reduce employment and output. The rate of unemployment therefore returns to its natural rate of 7%, but the inflation rate is still 3%. The economy is now at C. The short-run Phillips curve has shifted from PC1 to PC2.
With the unemployment rate back at 7%, the government once again tries to reduce it to 4% by using expansionary monetary and fiscal policies. The unemployment rate falls temporarily to 4%, but the increase in aggregate demand causes the rate of inflation to rise from 3% to 6%. The economy moves along the short-run Phillips curve PC2 from C to D, as shown in the diagram. But the economy does not remain at D. As before, workers revise their inflationary expectations, and, as before, firms react by reducing employment and output. The unemployment rate returns to its natural rate of 7%, while the inflation rate remains at 6%, as shown by point E in the diagram. The short-run Phillips curve shifts from PC2 to PC3. Thus, the policy-makers attempts to force unemployment below its natural rate have resulted only in raising the rate of inflation from 0% to 6%. The accelerationists claim that further attempts will just continue the spiral. They therefore conclude that there is no long-run trade-off between inflation and unemployment.
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