Macroeconomics

demand-pull inflation

because high aggregate demand is responsible for this

type of inflation. High unemployment pulls the inflation rate down. The para-

meter

b

measures how responsive inflation is to cyclical unemployment.

The third term, 

u

, shows that inflation also rises and falls because of supply

shocks. An adverse supply shock, such as the rise in world oil prices in the 1970s,

implies a positive value of 

u

and causes inflation to rise. This is called cost-push

inflation

because adverse supply shocks are typically events that push up the

costs of production. A beneficial supply shock, such as the oil glut that led to a

fall in oil prices in the 1980s, makes 

u

negative and causes inflation to fall.

Inflation and Unemployment in the United States

Because inflation and unemployment are such important measures of econom-

ic performance, macroeconomic developments are often viewed through the

lens of the Phillips curve. Figure 13-3 displays the history of inflation and

CASE STUDY

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unemployment in the United States from 1960 to 2008. This data, spanning

almost half a century, illustrates some of the causes of rising or falling inflation.

The 1960s showed how policymakers can, in the short run, lower unemploy-

ment at the cost of higher inflation. The tax cut of 1964, together with expan-

sionary monetary policy, expanded aggregate demand and pushed the

unemployment rate below 5 percent. This expansion of aggregate demand con-

tinued in the late 1960s largely as a by-product of government spending for the

Vietnam War. Unemployment fell lower and inflation rose higher than policy-

makers intended.

The 1970s were a period of economic turmoil. The decade began with poli-

cymakers trying to lower the inflation inherited from the 1960s. President Nixon

imposed temporary controls on wages and prices, and the Federal Reserve engi-

neered a recession through contractionary monetary policy, but the inflation rate

fell only slightly. The effects of wage and price controls ended when the controls

were lifted, and the recession was too small to counteract the inflationary impact

of the boom that had preceded it. By 1972 the unemployment rate was the same

as a decade earlier, while inflation was 3 percentage points higher.

Beginning in 1973 policymakers had to cope with the large supply shocks

caused by the Organization of Petroleum Exporting Countries (OPEC). OPEC

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run