Notes

Based on an analysis similar to that of the last question, Phelps reasoned that there was a natural unemployment rate for the economy, determined by the rate at which employed workers are laid off and quit and the rate at which unemployed workers are able to find jobs. As we saw in the last question, a temporary shock to this system--for example, one that causes fewer workers to leave their jobs in a particular month--would cause unemployment to deviate from its natural rate for a while, but that eventually it would converge back to its natural rate. Phelps conjectured that such a shock might be caused by an unexpected increase in inflation, and this might temporarily reduce the unemployment rate.

Imagine that workers have been used to getting a wage increase of 0.5% per month because the annual inflation rate is 6%. Then, suddenly they find that they are being offered a 1% increase this month and are told that they will get an additional 1% increase in subsequent months. This makes staying at their current job sound pretty attractive. Workers who had planned to quit might decide to stay because they think their current employer is raising their pay at a faster rate.

In fact, the inflation rate has doubled to 12% per year, so all wages and prices start going up by 1% per month. However, these workers do not realize this at first. They had been expecting inflation of only 0.5% per month. Their misunderstanding could cause a reduction in the job separation rate that is similar to the scenario described in the previous question. A reduction in the job separation rate will reduce the unemployment rate, just as it did in the previous question.

Suppose that inflation persists at the higher level of 1% per month. Once the workers realize that their increased dollar wages do not buy them any more goods than before and that wages are also growing by 1% per month at all other firms, everything goes back to normal. Workers quit at the same rate as before the change in inflation. The job separation rate returns to its normal value. As a result, unemployment will gradually return to the natural rate. So in the end, the inflation rate will be higher--12% per year instead of 6% per year--but the unemployment rate will converge back to the natural rate.