Introduction to Macroeconomics Chapter 22 Short run tradeoff between inflation and unemployment

Goals of Gov’t Policies Recall that monetary and fiscal policy should be used to stabilize the economy: Decrease unemployment (promote economic growth) Decrease inflation But there is a short run tradeoff: To decrease inflation leads to increase unemployment To decrease unemployment leads to increase inflation

Phillips Curve Phillips Curve illustrates the tradeoff between inflation and unemployment In the LR: due to monetary neutrality and classical dichotomy  NO TRADEOFF In the SR: the tradeoff is based on the short run equilibrium in the AD-AS model

Unemployment in the long run is determined by: Structural Barriers Frictional Unemployment Prices do not affect the natural rate of unemployment

Short Run Phillips Curve U = NRU – a(actual inf. – expected inf.) When expectations match actual inflation: U = NRU When expectations > actual = U < NRU When expectations < actual = U > NRU Why Inflation Expectations Matter: http://realestate.aol.com/blog/videos/green-living/519043174/

Application 1 Consider the impact of expansionary monetary policy on the AD-AS model. Illustrate the AD-AS model and impact of the change in monetary policy What happens to the price level? How does this impact inflation? What happens to output? How does this affect unemployment? Illustrate this effect on the Short Run Phillips Curve

Application 2 Now consider the impact of an oil shock on the economy. What if the price of oil increased suddenly from $50 per barrel to $100 per barrel? Illustrate the AD-AS model and impact of the change. What happens to the price level? How does this impact inflation? What happens to output? How does this affect unemployment? Illustrate this effect on the Short Run Phillips Curve Can the government counter this effect? If so, how? What impact would the government intervention have on inflation and unemployment?

Short Run Tradeoffs To stabilize the economy in times of shocks or recessions, the government faces a tradeoff Act to lower inflation (decrease AD) at the cost of higher unemployment Act to lower unemployment (increase AD) at the cost of higher inflation Can’t do both!

Key Takeaways The Phillips Curve provides guidance for policymakers in the short run in deciding to reach inflation or unemployment targets Links what happens in the aggregate economy (AD-AS model) to inflation and unemployment outcomes in the economy