Ch. 22 Reflection: The Short-Run Trade-Off Between Inflation and Unemployment

Ch. 22 Reflection: The Short-Run Trade-Off Between Inflation and Unemployment

 A good example of the short-run trade-off between inflation and unemployment is described as the Volcker Disinflation. Paul Volcker, chairman of the Fed was put in a tough situation at the end of the 1970s when OPEC had increased the cost of oil by reducing supply. In order to rein in inflation from 10% down to something more reasonable and plateable by the American public, Volcker had to sacrifice high unemployment in order to lower inflation. Volcker achieves this through tough monetary anti-inflation policies or contractionary policies. This was also countering the fiscal policies at the time in which the Reagan administration was increasing budget deficits which expanded aggregate demand and would normally have increased inflation. Because of the fiscal policy at the time, Volcker’s adjustment took the form of Phillips Curve, was eventually expected inflation fell and the Phillips curve shifted downward. This is illustrated in Figure 11 of the textbook, whereby in 1987, we had reached the natural rate of unemployment.

I am curious that if the Carter administration had stayed in office, would things have turned out differently for Volker? Could he have instituted policy changes in line with the rational expectations theory, therefore reducing or eliminating the trade-off between inflation and unemployment? I believe that if the administration at the time had been enacting fiscal policies in line with Volker, then the rational expectations theory may have prevailed over the Phillips Curve. 

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