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The Short-Run
Tradeoff between
Inflation and
Unemployment
Copyright © 2004 South-Western

35
Unemployment and Inflation
• The natural rate of unemployment depends on
various features of the labor market.
• Examples ...
Unemployment and Inflation
• Society faces a short-run tradeoff between
unemployment and inflation.
• If policymakers expa...
THE PHILLIPS CURVE
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.

Copyri...
The Phillips Curve

Inflation
Rate
(percent
per year)
B

6

A

2

Phillips curve
0

4

7

Unemployment
Rate (percent)
Copy...
The Phillips Curve and AS-AD

(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level

102

Inflation
Rate
(per...
Short-Run Phillips Curve
• The Phillips curve seems to offer policymakers
a menu of possible inflation and unemployment
ou...
The Long-Run Phillips Curve
• In the 1960s, Friedman and Phelps concluded
that inflation and unemployment are unrelated
in...
The Long-Run Phillips Curve

Inflation
Rate

1. When the
Fed increases
the growth rate
of the money
supply, the
rate of in...
The Phillips Curve and AS-AD

(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level

P2
2. . . . raises
the p...
Expectations and the SRPC
• Expected inflation measures how much people
expect the overall price level to change.

Copyrig...
Expectations and the SRPC
• In the long run, expected inflation adjusts to
changes in actual inflation.
• The Fed’s abilit...
Expectations and the SRPC

Unemployment Rate =



Natural rate of unemployment - a Actual  Expected
inflation inflation
...
How Expected Inflation Shifts the SRPC

Inflation
Rate

2. . . . but in the long run, expected
inflation rises, and the sh...
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1 the phillips curve and the role of expectations

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Transcript of "1 the phillips curve and the role of expectations"

  1. 1. The Short-Run Tradeoff between Inflation and Unemployment Copyright © 2004 South-Western 35
  2. 2. Unemployment and Inflation • The natural rate of unemployment depends on various features of the labor market. • Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. • The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed. Copyright © 2004 South-Western
  3. 3. Unemployment and Inflation • Society faces a short-run tradeoff between unemployment and inflation. • If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. • If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. Copyright © 2004 South-Western
  4. 4. THE PHILLIPS CURVE • The Phillips curve illustrates the short-run relationship between inflation and unemployment. Copyright © 2004 South-Western
  5. 5. The Phillips Curve Inflation Rate (percent per year) B 6 A 2 Phillips curve 0 4 7 Unemployment Rate (percent) Copyright © 2004 South-Western
  6. 6. The Phillips Curve and AS-AD (a) The Model of Aggregate Demand and Aggregate Supply Price Level 102 Inflation Rate (percent per year) Short-run aggregate supply 6 B 106 B A High aggregate demand Low aggregate demand 0 (b) The Phillips Curve 7,500 8,000 (unemployment (unemployment is 7%) is 4%) Quantity of Output A 2 Phillips curve 0 4 (output is 8,000) Unemployment 7 (output is Rate (percent) 7,500) Copyright © 2004 South-Western
  7. 7. Short-Run Phillips Curve • The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes. • But… Copyright © 2004 South-Western
  8. 8. The Long-Run Phillips Curve • In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. • As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. • Monetary policy could be effective in the short run but not in the long run. Copyright © 2004 South-Western
  9. 9. The Long-Run Phillips Curve Inflation Rate 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . . High inflation Low inflation 0 Long-run Phillips curve B A Natural rate of unemployment 2. . . . but unemployment remains at its natural rate in the long run. Unemployment Rate Copyright © 2004 South-Western
  10. 10. The Phillips Curve and AS-AD (a) The Model of Aggregate Demand and Aggregate Supply Price Level P2 2. . . . raises the price P level . . . Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand . . . (b) The Phillips Curve Inflation Rate Long-run Phillips curve 3. . . . and increases the inflation rate . . . B A A AD2 Aggregate demand, AD 0 Natural rate of output Quantity of Output 0 Natural rate of unemployment Unemployment Rate 4. . . . but leaves output and unemployment at their natural rates. Copyright © 2004 South-Western
  11. 11. Expectations and the SRPC • Expected inflation measures how much people expect the overall price level to change. Copyright © 2004 South-Western
  12. 12. Expectations and the SRPC • In the long run, expected inflation adjusts to changes in actual inflation. • The Fed’s ability to create unexpected inflation exists only in the short run. • Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. Copyright © 2004 South-Western
  13. 13. Expectations and the SRPC Unemployment Rate =  Natural rate of unemployment - a Actual  Expected inflation inflation  Copyright © 2004 South-Western
  14. 14. How Expected Inflation Shifts the SRPC Inflation Rate 2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Long-run Phillips curve C B Short-run Phillips curve with high expected inflation A 1. Expansionary policy moves the economy up along the short-run Phillips curve . . . 0 Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment Rate Copyright © 2004 South-Western
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