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MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

CONCEPT: SHORT-RUN PHILLIPS CURVE

● Two of the main macroeconomic concerns for policy makers are unemployment and inflation

□ However, it is hard to control both at the same time!

> If Aggregate Demand increases Price Level ____ and Unemployment ____

> If Aggregate Demand decreases Price Level ____ and Unemployment ____

EXAMPLE: Assume Year 1 is the base-year (price level = 100) and we are analyzing possible situations for Year 2.

Short-Run Phillips Curve

AD-AS Model Short-Run Phillips Curve

□ Phillips Curve – a graph showing the relationship between the _______________ and _______________

> As inflation increases, unemployment ________________

> As inflation decreases, unemployment ________________

ADH

ADL

SRAS

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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CONCEPT: LONG-RUN PHILLIPS CURVE

● Two of the main macroeconomic concerns for policy makers are unemployment and inflation

□ Recall, in the long run, the economy is functioning at its ______________ GDP

> Natural Rate of Unemployment – unemployment rate when economy is at ______________ GDP

> NAIRU – unemployment rate at which inflation has no tendency to increase or decrease

- Non-accelerating inflation rate of unemployment

> If Aggregate Demand increases Price Level ____ and Unemployment ____

> If Aggregate Demand decreases Price Level ____ and Unemployment ____

Long-Run Phillips Curve

AD-AS Model Long-Run Phillips Curve

AD2

AD1

LRAS

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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CONCEPT: SHIFTS IN SHORT-RUN PHILLIPS CURVE AND EXPECTED INFLATION

● Two of the main macroeconomic concerns for policy makers are unemployment and inflation

□ However, it is hard to control both at the same time!

□ The position of the short-run Phillips Curve is related to ____________ inflation

𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 =𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒

𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙

The real wage (purchasing power) adjusts the amount of dollars you are actually paid for the price level in the economy

- (i.e. The same nominal wage will buy less stuff at higher prices) If workers and firms expect a certain level of inflation (say 1.5%), but a higher inflation rate occurs (say 4.5%):

Expected Real Wage _____ Actual Real Wage

Firms will hire _______ workers leading to ________ unemployment

Price Level _____ and Unemployment ______, but ONLY because the inflation was ________________

If the new inflation rate (i.e. 4.5%) persists, it becomes the expected level of inflation Shifts the SR Phillips Curve Rational Expectations Theory – when forecasting the future, people use all publicly available information

- In this case, people are making rational decisions about the level of expected inflation

Long-Run Phillips Curve

Exp. Inflation = 1.5%

LR Phillips Curve

Exp. Inflation = 4.5%

5%

1.5%

4.5%

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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CONCEPT: SUPPLY SHOCK AND THE PHILLIPS CURVE

● Supply Shocks – an unexpected event that affects a firm’s production costs and shifts aggregate ___________

□ Generally, a supply shock involves an unexpected increase in input prices (like gasoline)

EXAMPLE: A sudden increase in gas prices affects the input costs of firm’s production

Short-Run Phillips Curve

AD-AS Model Short-Run Phillips Curve

□ Aggregate supply ____ Output ____ and Price Level _____

- This leaves policymakers in the difficult position of fighting _______ inflation and _______ unemployment

AD

SRAS

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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CONCEPT: SACRIFICE RATIO

● Expectations about inflation rates are a determinant of the position of the short-run Phillips Curve

□ If expected inflation increases Shift ___________

□ If expected inflation decreases Shift ___________

● The expected inflation in the economy has implications throughout:

□ Nominal Interest Rate vs. Real Interest Rate

- If expected inflation increases, nominal interest rates will also increase to stabilize the real interest rate

Assume the real interest rate a bank wants to earn is 5% on a loan. If expected inflation is equal to 2%, then: Now assume that expected inflation increases to 4%. To maintain the same real interest rate the bank would:

● If the Fed wishes to reduce the inflation rate, they must pursue ____________________ monetary policy

□ Money Supply ____ Interest Rates ____ Aggregate Demand ____ Price Level ____ and GDP ____

□ Sacrifice Ratio – percentage of GDP lost in the process of lowering inflation by 1%

𝑆𝑎𝑐𝑟𝑖𝑓𝑖𝑐𝑒 𝑅𝑎𝑡𝑖𝑜 =%∆𝐺𝐷𝑃

%∆𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

Sacrifice Ratio

LRPC

SRPC1

1. Contractionary policy

moves economy down

the SR Phillips Curve

2. In the LR, expected

inflation decreases, and

SR Phillips Curve shifts

left

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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CONCEPT: DISINFLATION AND DEFLATION

● Disinflation – a significant reduction in the _________________

□ Note that inflation is still _____________ during disinflation, but at a __________ rate

□ Historical context: USA in the 1970s-1980s and Paul Volcker Disinflation

● During the 1970s, the USA experienced high inflation rates

US Inflation Rates

Source: Bureau of Labor Statistics

● In 1979, President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserve

□ Volcker’s strict anti-inflation monetary policy brought inflation down from 10% down to 4%

□ Contractionary monetary policy brought inflation down, but increased short run unemployment (see graph below)

□ As workers and firms lowered their expectations of future inflation, the SR Phillips curve shifted left (same graph)

● Fiscal policy during the Reagan era of the 1980s did not help combat inflation

□ Increases in the budget deficit through increased spending, led to higher aggregate demand more inflation

Phillips Curve and Contractionary Policy

LRPC

SRPC1

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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● Deflation – a decline in the price level

□ During deflation, the inflation rate is _____________

□ Note the difference between disinflation and deflation

> Disinflation – inflation still occurring but at a slower rate

> Deflation – lower price level in the economy

Year Consumer Price Index

Inflation Rate

1929 17.1 0.0%

1930 16.7 -2.3%

1931 15.2 -9.0%

1932 13.7 -9.9%

1933 13.0 -5.1%

1979 72.6 11.3%

1980 82.4 13.5%

1981 90.9 10.3%

1982 96.5 6.2%

1983 99.6 3.2%

MACROECONOMICS - CLUTCH

CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

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