The Inexorable and Mysterious Tradeoff between Inflation and Unemployment

Questions & answers

Q1. What precisely does Mankiw mean by “the inflation-unemployment tradeoff,” and why call it “inexorable”?

Not a stable statistical scatterplot relationship, but “a statement about the effects of monetary policy. It is the claim that changes in monetary policy push these two variables in opposite directions” (Section “What is the inflation-unemployment tradeoff?”, p. 2). He calls it inexorable “because it is impossible to make sense of the business cycle, and in particular the short-run effects of monetary policy, unless we admit the existence of a tradeoff between inflation and unemployment” (p. 2), tracing the underlying idea to Hume’s 1752 essay “Of Money,” which observed that a monetary injection “must first quicken the diligence of every individual, before it increases the price of labour” – output and employment respond before prices do (p. 2-3).

Q2. What consensus view of monetary policy’s effects does the paper take as the empirical benchmark?

“There is wide agreement about two basic facts. First, shocks to monetary policy affect unemployment, at least temporarily. Second, shocks to monetary policy have a delayed and gradual effect on inflation” (Section on impulse response functions, p. 17). The paper illustrates the delayed-inflation-effect claim with both the historical Volcker disinflation (started October 1979, but “the big declines in inflation came in 1981 and 1982”) and formal VAR evidence, citing Bernanke and Gertler’s (1995) finding that monetary policy shocks “have no effect on the price level at all during the twelve months after the shock” (p. 17), while flagging that not all VAR studies agree (e.g., Rotemberg and Woodford 1997 find a much faster impact).

Q3. What is the “impulse response function” test, and why does the author think it is the right way to judge a Phillips curve model?

Because any specific model of the Phillips curve links inflation and unemployment with particular leads and lags, positing an inflation impulse response (the consensus delayed-and-gradual pattern) lets one algebraically derive the unemployment impulse response the model implies, which can then be checked against known facts: “If I tell you how inflation responds to a monetary policy shock, the Phillips curve tells you how unemployment must respond. And vice versa… we can gauge the model’s empirical validity” (Section on impulse response functions, p. 16). Mankiw stresses that the specific numbers he assigns to the inflation impulse response are illustrative – “feel free to disagree with the particular numbers: the only thing I need for my argument is that the effect of monetary policy on inflation is delayed and gradual” (p. 18-19).

Q4. How do traditional backward-looking Phillips curve models perform on this test?

They pass, essentially by construction: a simple backward-looking model (inflation depends on lagged inflation and the unemployment gap) implies unemployment rises temporarily in response to a contractionary shock, and adding a bit of hysteresis (the natural rate drifting toward the actual rate) lets some of that rise persist indefinitely – both “at least approximately correct” against the consensus facts (Section on impulse response functions, p. 18-19). Mankiw immediately qualifies this success: “it is, of course, not a major intellectual victory for these backward-looking models to produce empirically reasonable impulse response functions… The problem with them is that they have no good theoretical foundations” (p. 19).

Q5. What is the central negative result for the “new Keynesian Phillips curve”?

Fed the same delayed-and-gradual inflation impulse response, the forward-looking new Keynesian Phillips curve implies “a contractionary monetary shock that causes a delayed and gradual decline in inflation should cause unemployment to fall during the transition. This is precisely the opposite of what we know to be true” (Section on impulse response functions, p. 19-20). The mechanism: firms that are adjusting prices, on learning a disinflation is underway, would want to cut prices immediately – but the model’s assumed inflation path says they don’t, which is only consistent with rational, forward-looking price-setting if those firms are simultaneously revising down their expectations of future unemployment, i.e., anticipating an economic boom rather than a slump (p. 19-20).

Q6. How does this result connect to the earlier Ball and Fuhrer-Moore findings the paper cites?

Mankiw presents his impulse-response framing as a sharper restatement of both: Ball’s result that in this class of model, “a fully credible announced disinflation should cause an economic boom,” and Fuhrer and Moore’s finding that the model “has trouble generating the inflation persistence we observe in the data” (Section “How Can the Problem Be Fixed?”, p. 20-21). His contribution is to note that because monetary shocks are already known to have a delayed, gradual effect on inflation, “in essence we experience a credible announced disinflation every time we get a contractionary shock. Yet we don’t get the boom that the model says should accompany it” – and forcing the model to match the observed inflation persistence forces it into the implausible unemployment prediction as an unavoidable byproduct (p. 21).

Q7. Which candidate fixes does the paper consider, and why does it find none of them satisfying?

Three: Fuhrer-Moore-style labor contracts that average past and expected future inflation, imperfect/delayed information among price-setters (à la Rotemberg-Woodford), and adaptive (non-rational) expectations (Section “How Can the Problem Be Fixed?”, p. 21-22). The Fuhrer-Moore specification “takes a step in the direction of greater realism, but not nearly a big enough step to yield empirically plausible results” (unemployment still falls at first) (p. 21); a short information delay of one or two periods “doesn’t help the model match reality” beyond that short horizon, and longer delays “give up the hope of building a model on solid microfoundations” (p. 22); and while assuming adaptive expectations “reduces [the model] to the backward-looking model, which works just fine,” this is “far from a satisfying resolution” because “the public is not ignorant about monetary shocks… it is odd to assert that expectations about inflation are formed without incorporating this news” (p. 22).

Q8. What is the paper’s final verdict – is the tradeoff itself in doubt?

No – the existence of the short-run tradeoff is “good news” and secure (“almost all economists today agree that monetary policy influences unemployment, at least temporarily, and determines inflation, at least in the long run”), and its theoretical basis in price stickiness is well understood; the “bad news” is confined to the dynamic relationship between the two variables (Conclusion, p. 23). “The so-called ’new Keynesian Phillips curve’ is appealing from a theoretical standpoint, but it is ultimately a failure. It is not at all consistent with the standard stylized facts about the dynamic effects of monetary policy… We can explain these facts with traditional backward-looking models… but these models lack any foundation in the microeconomic theories of price adjustment” (p. 23). Mankiw frames this gap itself as a virtue for the field – “research areas attract interest when there are outstanding scientific puzzles to be solved” – rather than grounds for abandoning the tradeoff (Conclusion, p. 23).