1 the phillips curve and the role of expectations

Copyright © 2004 South-Western

35 The Short-Run

Tradeoff between

Inflation and

Unemployment


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.


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.


THE PHILLIPS CURVE

• The Phillips curve illustrates the short-run

relationship between inflation and

unemployment.

The Phillips Curve

Unemployment

Rate (percent)

0

Inflation

Rate

(percent

per year)

Phillips curve

4

B 6

7

A 2


The Phillips Curve and AS-AD

Quantity

of Output

0

Short-run

aggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment

Rate (percent)

0

Inflation

Rate

(percent

per year)

Price

Level

(b) The Phillips Curve

Phillips curve Low aggregate

demand

High

aggregate demand

(output is

8,000)

B

4

6

(output is

7,500)

A

7

2

8,000

(unemployment

is 4%)

106 B

(unemployment

is 7%)

7,500

102 A



Short-Run Phillips Curve

• The Phillips curve seems to offer policymakers

a menu of possible inflation and unemployment

outcomes.

• But…


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.

The Long-Run Phillips Curve

Unemployment

Rate

0 Natural rate of

unemployment

Inflation

Rate Long-run

Phillips curve

B High

inflation

Low

inflation

A

2. . . . but unemployment

remains at its natural rate

in the long run.

1. When the

Fed increases

the growth rate

of the money

supply, the

rate of inflation

increases . . .


The Phillips Curve and AS-AD

Quantity

of Output

Natural rate

of output

Natural rate of

unemployment

0

Price

Level

P

Aggregate

demand, AD

Long-run aggregate

supply

Long-run Phillips

curve

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment

Rate

0

Inflation

Rate

(b) The Phillips Curve

2. . . . raises

the price

level . . .

1. An increase in

the money supply

increases aggregate

demand . . .

A

AD2

B

A

4. . . . but leaves output and unemployment

at their natural rates.

3. . . . and

increases the

inflation rate . . .

P2 B



Expectations and the SRPC

• Expected inflation measures how much people

expect the overall price level to change.



• 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.



Natural rate of unemployment - a Actual inflation

Expected inflation

Unemployment Rate =

How Expected Inflation Shifts the SRPC

Unemployment

Rate

0 Natural rate of

unemployment

Inflation

Rate Long-run

Phillips curve

Short-run Phillips curve

with high expected

inflation

Short-run Phillips curve

with low expected

inflation

1. Expansionary policy moves

the economy up along the

short-run Phillips curve . . .

2. . . . but in the long run, expected

inflation rises, and the short-run

Phillips curve shifts to the right.

C B

A


Business

1 the phillips curve and the role of expectations