The document discusses monetary policy and the Phillips curve. It explains that in the 1960s there appeared to be a stable trade-off between unemployment and inflation, but Milton Friedman later argued this was not permanent. The Phillips curve shows the relationship between inflation and unemployment in the short-run, while the long-run Phillips curve is vertical at the natural rate of unemployment. Monetary policy aims to reduce inflation permanently by influencing expectations of future inflation.

2. Why Does Whirlpool Care about Monetary Policy? Learning Objectives In 2006, Whirlpool, headquartered in Benton Harbor, Michigan, had 73,000 employees and $18 billion in annual sales. In 2001 and the following years, Whirlpool clearly benefited from the effects of monetary policy. Use a Phillips curve graph to show how the Federal Reserve can permanently lower the inflation rate . 16.4 Discuss how expectations of the inflation rate affect monetary policy. 16.3 Explain the relationship between the short-run and long-run Phillips curves . 16.2 Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation. 16.1

3. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate. Learning Objective 16.1 FIGURE 16.1 The Phillips Curve

4. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Learning Objective 16.1 Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves FIGURE 16.2 Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve

5. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Structural relationship A relationship that depends on the basic behavior of consumers and firms and remains unchanged over long periods. Learning Objective 16.1 Is the Phillips Curve a Policy Menu? Is the Short-Run Phillips Curve Stable? During the 1960s, the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation. Then in 1968, in his presidential address to the American Economic Association, Milton Friedman of the University of Chicago argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation.

6. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP. Learning Objective 16.1 The Long-Run Phillips Curve

7. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Learning Objective 16.1 The Long-Run Phillips Curve FIGURE 16.3 A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve

8. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Learning Objective 16.1 The Role of Expectations of Future Inflation Table 16-1 The Impact of Unexpected Price Level Changes on the Real Wage $31.50 Actual P 2012 = 108 Actual Inflation = 8% Actual P 2012 = 102 Actual Inflation = 2% Expected P 2012 = 105 Expected Inflation = 5% ACTUAL REAL WAGE EXPECTED REAL WAGE NOMINAL WAGE

9. The Discovery of the Short-Run Trade-off between Unemployment and Inflation Learning Objective 16.1 The Role of Expectations of Future Inflation Table 16-2 The Basis for the Short-Run Phillips Curve the unemployment rate rises. the actual real wage is greater than the expected real wage, actual inflation is less than expected inflation, the unemployment rate falls. the actual real wage is less than the expected real wage, actual inflation is greater than expected inflation, AND… THEN… IF…

10. Do Workers Understand Inflation? Learning Objective 16.1 Will her wage increases keep up with inflation? Making the Connection

11. The Short-Run and Long-Run Phillips Curves Learning Objective 16.2 FIGURE 16.4 The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve

12. The Short-Run and Long-Run Phillips Curves Learning Objective 16.2 FIGURE 16.5 Expectations and the Short-Run Phillips Curve Shifts in the Short-Run Phillips Curve

13. The Short-Run and Long-Run Phillips Curves Learning Objective 16.2 FIGURE 16.6 A Short-Run Phillips Curve for Every Expected Inflation Rate Shifts in the Short-Run Phillips Curve

14. The Short-Run and Long-Run Phillips Curves Learning Objective 16.2 FIGURE 16.7 The Inflation Rate and the Natural Rate of Unemployment in the Long Run How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

15. The Short-Run and Long-Run Phillips Curves Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease. Learning Objective 16.2 How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

16. Does the Natural Rate of Unemployment Ever Change? Learning Objective 16.2 What makes the natural rate of unemployment increase or decrease? Frictional or structural unemployment can change—thereby changing the natural rate—for several reasons: • Demographic changes. • Labor market institutions. • Past high rates of unemployment. Making the Connection

17. Changing Views of the Phillips Curve Learning Objective 16.2 Writing in a Federal Reserve publication, Bennett McCallum, an economist at Carnegie Mellon University, argues that during the 1970s, the Fed was “acting under the influence of 1960s academic ideas that posited the existence of a long-run and exploitable Phillips-type tradeoff between inflation and unemployment rates.” Solved Problem 16-2

18. Expectations of the Inflation Rate and Monetary Policy • Low inflation. • Moderate but stable inflation. • High and unstable inflation. Learning Objective 16.3 Rational expectations Expectations formed by using all available information about an economic variable. The experience in the United States over the past 50 years indicates that how workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities:

19. Expectations of the Inflation Rate and Monetary Policy Learning Objective 16.3 The Effect of Rational Expectations on Monetary Policy FIGURE 16.8 Rational Expectations and the Phillips Curve

20. Expectations of the Inflation Rate and Monetary Policy Learning Objective 16.3 Many economists have remained skeptical of the argument that the short-run Phillips curve is vertical. The two main objections raised are that workers and firms actually may not have rational expectations, and the rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place. Is the Short-Run Phillips Curve Really Vertical? Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP. Real Business Cycle Models

21. How the Fed Fights Inflation Learning Objective 16.4 The Effect of a Supply Shock on the Phillips Curve FIGURE 16.9 A Supply Shock Shifts the SRAS and the Short-Run Phillips Curve

22. How the Fed Fights Inflation Learning Objective 16.4 Paul Volcker and Disinflation FIGURE 16.10 The Fed Tames Inflation, 1979–1989

23. How the Fed Fights Inflation Learning Objective 16.4 Disinflation A significant reduction in the inflation rate. Paul Volcker and Disinflation Don’t Let This Happen to YOU! Don’t Confuse Disinflation with Deflation -5.1 13.0 1933 -9.9 13.7 1932 -9.0 15.2 1931 -2.3% 16.7 1930 - 17.1 1929 DEFLATION RATE CONSUMER PRICE INDEX YEAR

24. Using Monetary Policy to Lower the Inflation Rate Learning Objective 16.4 Solved Problem 16-4

25. How the Fed Fights Inflation Learning Objective 16.4 Alan Greenspan and the Importance of a Credible Monetary Policy Table 16-3 The Record of Fed Chairmen and Inflation 3.0 January 2006– Ben Bernanke 3.0 August 1987-(January 2006) Alan Greenspan 6.2 August 1979-August 1987 Paul Volcker 9.2 March 1978-August 1979 G. William Miller 6.5 February 1970-January 1978 Arthur Burns 2.0% April 1952-January 1970 William McChesney Martin AVERAGE ANNUAL INFLATION RATE DURING TERM TERM FEDERAL RESERVE CHAIRMAN

26. How the Fed Fights Inflation Learning Objective 16.4 De-emphasizing the Money Supply The Importance of Fed Credibility The Fed learned an important lesson during the1970s: Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective.

27. How the Fed Fights Inflation Learning Objective 16.4 Monetary Policy Credibility after Greenspan A Failure of Credibility at the Bank of Japan Debate continues over policies to increase the Fed’s credibility. Some economists and policymakers believe that central banks are more credible if they adopt and follow rules. Economists and policymakers who oppose the rules strategy support a discretion strategy for monetary policy Many economists believe a middle course between a rules strategy and a discretion strategy is desirable. Most economists believe the best way to achieve commitment to rules is to remove political pressures on the central bank.

28. How the Fed Fights Inflation Learning Objective 16.4 Federal Reserve Policy and Whirlpool’s “Pricing Power” The success of any firm, particularly a firm like Whirlpool that produces consumer durables, will be determined partly by its ability to compete against rival firms and partly by macroeconomic conditions.

29. An Inside LOOK The Fed Rethinks the Phillips Curve Policy Makers at Fed Rethink Inflation’s Roots The short- and long-run Phillips curves.

30. Disinflation Natural rate of unemployment Nonaccelerating inflation rate of unemployment (NAIRU) Phillips curve Rational expectations Real business cycle models Structural relationship K e y T e r m s