I n t h I s c h a p t e r y o u w I l L

AD
1
to 
AD
2
, the equilibrium
moves from point A to point B. The price level rises from 
P
1
to 
P
2
, while output remains
the same. Panel (b) shows the long-run Phillips curve, which is vertical at the natural 
rate of unemployment. Expansionary monetary policy moves the economy from 
lower inflation (point A) to higher inflation (point B) without changing the rate of
unemployment.

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7 7 0
PA R T T W E LV E
S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
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):

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C H A P T E R 3 3
T H E S H O R T - R U N T R A D E O F F B E T W E E N I N F L AT I O N A N D U N E M P L O Y M E N T
7 7 1
⫽
⫺
a
冢
⫺
冣
.
This equation relates the unemployment rate to the natural rate of unemployment,
actual inflation, and expected inflation. In the short run, expected inflation is
given. As a result, higher actual inflation is associated with lower unemployment.
(How much unemployment responds to unexpected inflation is determined by the
size of 
a,
a number that in turn depends on the slope of the short-run aggregate-
supply curve.) In the long run, however, people come to expect whatever inflation
the Fed produces. Thus, actual inflation equals expected inflation, and unemploy-
ment is at its natural rate.
This equation implies there is no stable short-run Phillips curve. Each short-
run Phillips curve reflects a particular expected rate of inflation. (To be precise, if
you graph the equation, you’ll find that the short-run Phillips curve intersects the
long-run Phillips curve at the expected rate of inflation.) Whenever expected in-
flation changes, the short-run Phillips curve shifts.
According to Friedman and Phelps, it is dangerous to view the Phillips curve
as a menu of options available to policymakers. To see why, imagine an economy
at its natural rate of unemployment with low inflation and low expected inflation,
shown in Figure 33-5 as point A. Now suppose that policymakers try to take ad-
vantage of the tradeoff between inflation and unemployment by using monetary
or fiscal policy to expand aggregate demand. In the short run when expected in-
flation is given, the economy goes from point A to point B. Unemployment falls be-
low its natural rate, and inflation rises above expected inflation. Over time, people
get used to this higher inflation rate, and they raise their expectations of inflation.
When expected inflation rises, firms and workers start taking higher inflation into
Expected
inflation
Actual
inflation
Natural rate of
unemployment
Unemployment
rate
Unemployment
Rate
0
Natural rate of
unemployment
Inflation
Rate
C
B
Long-run
Phillips curve
A
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Expansionary policy moves
the economy up along the 
short-run Phillips curve . . . 
2. . . . but in the long run, expected
inflation rises, and the short-run 
Phillips curve shifts to the right.
F i g u r e 3 3 - 5
H
OW
E
XPECTED
I
NFLATION
S
HIFTS THE
S
HORT
-R
UN
P
HILLIPS
C
URVE
.
The higher the
expected rate of inflation, the
higher the short-run tradeoff
between inflation and
unemployment. At point A,
expected inflation and actual
inflation are both low, and
unemployment is at its natural
rate. If the Fed pursues an
expansionary monetary policy,
the economy moves from point A
to point B in the short run. At
point B, expected inflation is still
low, but actual inflation is high.
Unemployment is below its
natural rate. In the long run,
expected inflation rises, and the
economy moves to point C. At
point C, expected inflation and
actual inflation are both high,
and unemployment is back
to its natural rate.

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7 7 2
PA R T T W E LV E
S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
account when setting wages and prices. The short-run Phillips curve then shifts to
the right, as shown in the figure. The economy ends up at point C, with higher in-
flation than at point A but with the same level of unemployment.
Thus, Friedman and Phelps concluded that policymakers do face a tradeoff be-
tween inflation and unemployment, but only a temporary one. If policymakers use
this tradeoff, they lose it.
T H E N AT U R A L E X P E R I M E N T
F O R T H E N AT U R A L - R AT E H Y P O T H E S I S
Friedman and Phelps had made a bold prediction in 1968: If policymakers try to
take advantage of the Phillips curve by choosing higher inflation in order to re-
duce unemployment, they will succeed at reducing unemployment only tem-
porarily. This view—that unemployment eventually returns to its natural rate,
regardless of the rate of inflation—is called the