[MUSIC] At different times in global economic history, inflation has spiraled out of control, sometimes in spectacular hyperinflation fashion. The poster child for inflationary spirals and hyperinflation are the Wymer Republic of Germany in the 1920's, and Hungary, right after World War II, in the 1940's. In Germany, at the height of the spiral, $1 was worth 4 trillion German while in Hungary, inflation doubled daily. Yes, everyday, during the worst of the crisis. While these examples are extreme, the 1970s of the last century also featured double digit inflation rates in America with much of the latter part of that difficult decade. In the 1970s, very long ago that they may be, actually turn out to be a very good laboratory for exploring the causes of and cures for an inflationary spiral, and for the introduction of a very useful tool known as the Phillip's curve. [MUSIC] The Phillip's curve was developed by English economist A.W. Phillips from his study of more than a century's worth of data on unemployment and money wages in the United Kingdom. [SOUND] From his data analysis, Phillip's found an inverse relationship between the rate of inflation and the rate of unemployment, to it as the unemployment rate falls, the more robust GDP growth rate, the inflation rate rises. To convey the idea of the Phillip's curve, take a look at the aggregate supply, aggregate demand model in this figure. Holding the aggregate supply curve steady, we start at AD not, but an increase in aggregate demand shifts the AD curve upwards from AD1, to AD2, and eventually to AD3. The result is that the price level rises from P not to P3 while output increases, From Q not to Q3. So what do you think happens to the unemployment rate as output rises? Take a minute now to jot down your answer. [MUSIC] [SOUND] Well unless robots are doing all the work, the increase in real output will almost certainly be accompanied by a fall in the unemployment rate as the price level is rising. In fact, this is the essence of the Phillip's curve relationship, and it is illustrated in this figure. [NOISE] This figure shows the theoretical inverse relationship between inflation and unemployment. So if the unemployment rate is, say around 5%, the inflation rate is around 2%. But what happens if the unemployment rate drops to around 2%? What will be the inflation rate? Please quickly jot down your answer before moving on. [MUSIC] That's right, the annual rate of inflation will jump to around 6%. Now take a look at this figure, which charts the co-movements of the rates of inflation and unemployment between 1961 and 1969, and note the nice downward sloping curve, which appears to provide strong empirical evidence that Phillip's curve and the inverse relationship between inflation and the unemployment actually exist. On the basis of this, and earlier historical evidence, most economists came to believe, prior to the 1970s, that the stable predictable trade off exists between unemployment and inflation, and here's the key point in macroeconomic policy implication for the use of discretionary Keynesian stimulus policies. If there is indeed a predictable tradeoff between unemployment and inflation, the government can always use fiscal or monetary policy to expand the economy a bit more to reduce unemployment, and the only price a nation would pay is a bit more inflation. That's not a bad Keynesian stimulus trade off to keep people employed. [SOUND] The 1970s came along, however, to cast a long shadow of doubt over the very existence of the y77 Curl, and therefore, the efficacy of Keynesian stimulus. [MUSIC] So just what happened in the 1970s to shake economists' faith in the Phillip's Curve? Let's find out by looking at what happens to our Phillip's Curve when you add data points to the stagflation years, 1971 to 1979, showing the co-movements of the rates of inflation and unemployment. Wow. In this case, the nice downward Phillip's curve turns into a squiggly looking, an upward-sloping Phillip's curl suggesting that there may be no relationship between the rates of inflation and unemployment at all. Of course, if that is the case, the Keynesian stimulus may only lead to inflation. [SOUND] So is there a tradeoff between the rates of inflation and unemployment or not? That, in fact, is the mystery that we're going to try to solve in our next module as we introduce the monitors concept, of the natural rate of unemployment, and analyze the possible origins of inflationary spirals. So, when you're ready, let's move on. [MUSIC]
