The Short-Run Policy Tradeoff: Unemployment and Inflation When you have completed this presentation, you will be able to 1 Distinguish between Demand-Pull and Cost Push Inflation 2 Describe the short-run policy tradeoff between inflation and unemployment. 3 Distinguish between the short-run and long-run Phillips curves and describe the shifting tradeoff between inflation and unemployment. Notes and teaching tips: 4-5 and 7. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure. To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Short Run - Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Long Run - Period in which nominal wages are fully responsive to previous changes in the price level

SHORT-RUN AGGREGATE SUPPLY A higher price level increases profits and output moving the economy from a1 to a2. AS1 P2 a2 Price Level P1 a1 o Qf Q2 Real domestic output

SHORT-RUN AGGREGATE SUPPLY A lower price level decreases profits and output moving the economy from a1 to a3 . AS1 P2 a2 Price Level P1 a1 P3 a3 o Q3 Qf Q2 Real domestic output

LONG-RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left . ASLR AS2 b1 AS1 P2 a2 a1 Price Level P1 o Qf Real domestic output

LONG-RUN AGGREGATE SUPPLY A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right . ASLR AS2 b1 AS1 P2 a2 AS3 a1 Price Level P1 P3 a3 c1 o Qf Real domestic output

EQUILIBRIUM IN THE EXTENDED AD-AS MODEL ASLR AS1 Price Level P1 a AD1 o Qf Real domestic output

DEMAND-PULL INFLATION ASLR AS2 AS1 c P3 Price Level P2 b P1 a AD2 AD1 o Qf Q1 Real domestic output

COST-PUSH INFLATION Occurs when short-run AS shifts left Price Level o ASLR AS2 AS1 Price Level P2 b P1 a AD1 o Q2 Qf Real domestic output

COST-PUSH INFLATION Even higher price levels Government response with increased AD ASLR AS2 AS1 Even higher price levels c P3 Price Level P2 b P1 a AD2 AD1 o Q2 Qf Real domestic output

COST-PUSH INFLATION If government allows a recession to occur ASLR AS2 AS1 Price Level P2 b P1 a AD1 o Q2 Qf Real domestic output

COST-PUSH INFLATION If government allows a recession to occur Nominal ASLR AS2 AS1 Nominal wages fall & AS returns to its original location Price Level P2 b P1 a AD1 o Q2 Qf Real domestic output

THE INFLATION-UNEMPLOYMENT RELATIONSHIP Normally, there is a short-run trade-off between the rate of inflation and the the rate of unemployment. Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment. There is no significant trade-off over long periods of time.

THE SHORT-RUN PHILLIPS CURVE Short-run Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate when the natural unemployment rate and the expected inflation rate remain constant. Economist AWH Phillips The story of the Phillips curve is a wonderful illustration of how the science of economics advances. The story I tell starts in 1958 when A. W. Phillips published his empirical work. At that time the mainstream economic model was quite different from the AS-AD model derived in the text. Essentially, it was similar to the simple aggregate expenditure model presented in Chapter 29. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, though, the inflation rate began to creep higher and averaged 2.7 percent a year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. [Continued on next slide]

Annual rate of inflation Unemployment rate (percent) THE PHILLIPS CURVE CONCEPT 7 6 5 4 3 2 1 As inflation declines... unemployment increases Annual rate of inflation (percent) 1 2 3 4 5 6 7 Unemployment rate (percent)

THE SHORT-RUN PHILLIPS CURVE Aggregate Supply and the Short-Run Phillips Curve The AS-AD model explains the negative relationship between unemployment and inflation along the short-run Phillips curve. The short-run Phillips curve is another way of looking at the upward-sloping aggregate supply curve. Both curves arise because the money wage rate is fixed in the short run.

THE SHORT-RUN PHILLIPS CURVE So a movement along the AS curve is equivalent to a movement along the short-run Phillips curve. Unemployment and Real GDP At full employment, the quantity of real GDP is potential GDP and the unemployment rate is the natural unemployment rate. If real GDP exceeds potential GDP, employment exceeds its full-employment level and the unemployment rate falls below the natural unemployment rate.

THE SHORT-RUN PHILLIPS CURVE Similarly, if real GDP is less than potential GDP, employment is less than its full employment level and the unemployment rate rises above the natural unemployment rate. Okun’s Law For each percentage point change in unemployment there is a 2 percent change in GDP, for every percentage point that unemployment is above the natural rate of unemployment then real GDP is 2 percent below potential GDP.    InOW: For every 1% you are above the natural rate, you lose 2% of GDP. Or for every 1% cyclical unemployment, you lose 2% GDP. 

What is the negative GDP Gap? 2. The UE rate = 5% Okun’s Law Cont’d Examples 1. The UE rate = 6.5% Full Employment = 4.5% What is the negative GDP Gap? 2. The UE rate = 5% What is the GDP output gap?

THE SHORT-RUN PHILLIPS CURVE Aggregate Demand Fluctuations Aggregate demand fluctuations bring movements along the aggregate supply curve and equivalent movements along the short-run Phillips curve.

SHORT-RUN AND LONG-RUN ... The long-run Phillips curve is a vertical line at the natural unemployment rate. In the long run, there is no unemployment-inflation tradeoff.

SHORT-RUN AND LONG-RUN ... The Natural Rate Hypothesis The natural rate hypothesis is the proposition that when the inflation rate changes, the unemployment rate changes temporarily and eventually returns to the natural unemployment rate.

SHORT-RUN AND LONG-RUN ... The inflation rate is 3 percent a year and the economy is at full employment, at point A. Then the inflation rate increases. In the short run, the increase in inflation brings a decrease in the unemployment rate — a movement along SRPC0 to point B.

SHORT-RUN AND LONG-RUN ... Eventually, the higher inflation rate is expected and the short-run Phillips curve shifts upward to SRPC1. At the higher expected inflation rate, unemployment returns to the natural unemployment rate—the natural rate hypothesis.

30.2 SHORT-RUN AND LONG-RUN ... Changes in the Natural Unemployment Rate If the natural unemployment rate changes, both the long-run Phillips curve and the short-run Phillips curve shift. When the natural unemployment rate increases, both the long-run Phillips curve and the short-run Phillips curve shift rightward. When the natural unemployment rate decreases, both the long-run Phillips curve and the short-run Phillips curve shift leftward.

30.2 SHORT-RUN AND LONG-RUN ... Figure 30.6 shows the effect of changes in the natural unemployment rate. The expected inflation rate is 3 percent a year. The natural unemployment rate is 6 percent.

30.2 SHORT-RUN AND LONG-RUN ... The short-run Phillips curve is SRPC0 and the long-run Phillips curve is LRPC0. An increase in the natural unemployment rate shifts the two Phillips curves rightward to LRPC1 and SRPC1.