The Inflation-Unemployment Trade-off at Low Inflation

IMF Working Papers, March 1, 2009

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The Inflation-Unemployment Trade-off at Low Inflation

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Bibliographic details

• Authors: Luca A Ricci, Pierpaolo Benigno
• Published: March 1, 2009
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451871814.001

Summary findings

• Wage setters account for future consequences of current wage choices when downward nominal wage rigidities are present.
• A closed-form solution for a long-run Phillips curve relates average unemployment to average wage inflation.
• The long-run Phillips curve is virtually vertical for high inflation rates but becomes flatter as inflation declines.
• Macroeconomic volatility shifts the Phillips curve outward, implying stabilization policies affect the trade-off.
• Nominal wages tend to be endogenously rigid also upward, at low inflation.
• When inflation decreases, volatility of unemployment increases whereas the volatility of inflation decreases; this implies a long-run trade-off between the volatility of unemployment and that of wage inflation.

Mechanisms and analysis

• Downward nominal wage rigidities alter wage-setters’ forward-looking optimization, generating changes in the shape of the long-run Phillips curve across inflation regimes.
• Increased macroeconomic volatility worsens the unemployment-inflation trade-off by shifting the Phillips curve outward.
• Endogenous upward nominal wage rigidity emerges at low inflation, reinforcing asymmetries in wage adjustment.
• Changes in inflation levels produce opposite effects on volatilities: lower inflation → higher unemployment volatility and lower inflation volatility.

Policy implications and recommendations

• Stabilization policies can play an important role in shaping the inflation-unemployment trade-off because macroeconomic volatility shifts the Phillips curve outward.
• Policymakers should account for endogenous wage rigidities (both downward and upward at low inflation) when designing policies aimed at reducing unemployment without igniting inflation.
• Managing macroeconomic volatility is crucial to improving long-run outcomes on the Phillips curve and reducing adverse volatility trade-offs.

Source: The Inflation-Unemployment Trade-off at Low Inflation, IMF Working Papers.

Content in this bundle

• _wp0934 — Introduction, sections 5.3, 6.1 and 6.3
  • _wp0934 — Introduction, sections 5.3, 6.1 and 6.3 (Markdown version)
  • _wp0934 — Introduction, sections 5.3, 6.1 and 6.3 (PDF)