1. THE ROLE AND NATURE OF INVESTMENT

Learning Objectives1. Draw a Phillips curve and describe the relationship

between inflation and unemployment that it expresses.2. Describe the other relationships or phases that have been

observed between inflation and unemployment.

1.1 The Phillips Curve

• The Phillips curve is a curve that suggests a negative relationship between inflation and unemployment.

1.2 The Phillips Curve Goes Awry

The Phillips Curve in the 1960’s (U.S.)

1.2 The Phillips Curve Goes Awry

When considering Unemployment and Inflation (U.S.) from 1961-2008 the data does not appear consistent with the theory behind the Phillips curve!

1.3 Cycles of Inflation and Unemployment

Unemployment and Inflation (U.S.) 1961-2002Sequential connections suggest a clockwise cyclical pattern

1.3 Cycles of Inflation and Unemployment

• The Phillips phase is the period in which inflation rises as unemployment falls.

• The stagflation phase is the period in which inflation remains high while unemployment increases.

• The recovery phase is a the period in which inflation and unemployment both decline.

• The Inflation-unemployment cycle is a pattern consisting of a Phillips phase, followed by stagflation, and then a recovery.

1.3 Cycles of Inflation and Unemployment

Phases of the Inflation-Unemployment cycle

2. EXPLAINING INFLATION-UNEMPLOYMENT RELATIONSHIPS

Learning Objectives1. Use the model of aggregate demand and aggregate

supply to explain a Phillips phase, a stagflation phase, and a recovery phase.

2.1 The Phillips Phase: Increasing Aggregate Demand

Phillips phase

3

21

3

21

LRAS

SRAS1,2,3

AD1 AD2

AD3

2.1 The Phillips Phase: Increasing Aggregate Demand

Real GDP (billions) Rate of unemployment (%)

$880 9.0

910 8.0

940 7.0

970 6.0

1,000 5.0

1,030 4.0

1,060 3.0

1,090 2.0

The relationship between GDP and unemployment from the previous slide.

2.2 Changes in Expectations and the Stagflation Phase

Phillips phase

3

21

32

1

LRAS

SRAS1,2,3

AD3,4

SRAS44

4

Stagflation phase

2.3 The Recovery Phase

3

21

LRAS

SRAS1,2,3

AD1 AD2

AD3,4

4

5AD5

SRAS4

Phillips phase

3

21

4

Stagflation phase

5 Recovery phase

3. INFLATION AND UNEMPLOYMENT IN THE LONG RUN

Learning Objectives1. Use the equation of exchange to explain what determines the inflation rate

in the long run.2. Explain why in the long run the Phillips curve is vertical.3. Describe frictional and structural unemployment and the factors that may

affect these two types of unemployment.4. Describe efficiency wage theory and its predictions concerning cyclical

unemployment.

3.1 The Inflation Rate in the Long Run

EQUATION 3.1

EQUATION 3.2

EQUATION 3.3

• Inflation rates and economic growth

YPVM %%%%

YMP %%%

PYPVM %%%%

3.1 The Inflation Rate in the Long Run

3.2 Unemployment in the Long Run

3.2 Unemployment in the Long Run

• Frictional unemployment– A reservation wage is the lowest wage that

an unemployed worker would accept, if it were offered.

Public Policy and Frictional Unemployment

t0 t2 t1

W1

W2

W0

BOR1BOR2

RW1

t0 t2t1

W1

W2

W0

BOR1

RW2

RW1

Programs that provide labor market information tend to shift the BOR cures of individual workers to the left, reducing the duration of the job search and unemployment, and increasing the wage.

Unemployment compensation tends to increase the duration over which a worker will hold out for a higher wage, shifting the RW curve to the right, increasing unemployment and the wage.

3.2 Unemployment in the Long Run

• Structural unemployment• Cyclical unemployment and efficiency wages

– Efficiency wage theory is based on the idea that firms may hold to a real wage greater than the equilibrium wage.