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  • 1.The Short-Run Tradeoff between Inflation and Unemployment Copyright 2004 South-Western35

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. 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. THE PHILLIPS CURVE The Phillips curve illustrates the short-run relationship between inflation and unemployment.Copyright 2004 South-Western 5. The Phillips CurveInflation Rate (percent per year) B6A2Phillips curve 047Unemployment Rate (percent) Copyright 2004 South-Western 6. The Phillips Curve and AS-AD(a) The Model of Aggregate Demand and Aggregate Supply Price Level102Inflation Rate (percent per year)Short-run aggregate supply6B106BA High aggregate demand Low aggregate demand0(b) The Phillips Curve7,500 8,000 (unemployment (unemployment is 7%) is 4%)Quantity of OutputA2 Phillips curve 04 (output is 8,000)Unemployment 7 (output is Rate (percent) 7,500)Copyright 2004 South-Western 7. Short-Run Phillips Curve The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes. ButCopyright 2004 South-Western 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. The Long-Run Phillips CurveInflation Rate1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .High inflationLow inflation0Long-run Phillips curve BANatural rate of unemployment2. . . . but unemployment remains at its natural rate in the long run.Unemployment RateCopyright 2004 South-Western 10. The Phillips Curve and AS-AD(a) The Model of Aggregate Demand and Aggregate Supply Price LevelP2 2. . . . raises the price P level . . .Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand . . .(b) The Phillips CurveInflation RateLong-run Phillips curve 3. . . . and increases the inflation rate . . . BAAAD2 Aggregate demand, AD0Natural rate of outputQuantity of Output0Natural rate of unemploymentUnemployment Rate4. . . . but leaves output and unemployment at their natural rates.Copyright 2004 South-Western 11. Expectations and the SRPC Expected inflation measures how much people expect the overall price level to change.Copyright 2004 South-Western 12. Expectations and the SRPC In the long run, expected inflation adjusts to changes in actual inflation. The Feds 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. Expectations and the SRPCUnemployment Rate =Natural rate of unemployment - a Actual Expected inflation inflationCopyright 2004 South-Western 14. How Expected Inflation Shifts the SRPCInflation Rate2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Long-run Phillips curveCBShort-run Phillips curve with high expected inflation A1. Expansionary policy moves the economy up along the short-run Phillips curve . . . 0Short-run Phillips curve with low expected inflationNatural rate of unemploymentUnemployment Rate Copyright 2004 South-Western