The Inflation/Output Trade-off Revisited

Describing the nature of the trade-off between inflation and output or unemployment has long been difficult and controversial. The Friedman-Phelps hypothesis, that there is no long-run Phillips curve trade-off between inflation and unemployment, has clearly won over most macro-. economists, but the debate has continued over what, if any, trade-off remains. The subtle notion that an uncertain short-run trade-off, but no long-run trade-off, exists between inflation and output has proved more difficult to analyze and describe. The debate over monetary policy tightening in the United States in 1994 illustrates some of these difficulties. The distinction between long-run and short-run trade-offs was again blurred as many commentators expressed concern that the Federal Reserve’s goal of low inflation would reduce real GDP growth. Typical of much financial and political reporting was a New York Times article on the rise in interest rates in 1994, which concluded, "the balance between.., more growth and less inflation, shifts again--toward a slower economy" (Uchitelle 1994). The article even quoted Paul Volcker for support: "If you have a weaker economy, you have lower [nominal interest] rates. That is not a great world but that is the way it is." But a long-term analysis of the output versus inflation or interest rate trade-off would be stated differently. A weaker economy does not imply a lower inflation rate or a lower interest rate: In 1978, the unemployment rate was 6 percent, while interest rates