Inflation and Unemployment: The Phillips Curve Lesson 35 Section 34

The Short-Run Phillips Curve The Short-Run Phillips Curve shows the short run trade off between inflation and unemployment. Quantity of Output Short-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (percent) Inflation Rate (percent per year) Price Level (b) The Phillips Curve Phillips curve Low aggregate demand High aggregate demand (output is 8,000) B 4 6 7,500) A 7 2 8,000 (unemployment is 4%) 106 is 7%) 7,500 102

Inflation and Unemployment in the Long-Run The Long-Run Phillips Curve The Natural Rate of Unemployment To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation. Nonaccelerating inflation rate of unemployment NAIRU Employment higher than NAIRU causes inflation The Costs of Disinflation Deliberately higher levels of unemployment to bring inflation down Quantity of Output Natural rate of output Natural rate of unemployment Price Level P Aggregate demand, AD Long-run aggregate supply Long-run Phillips curve (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate Inflation (b) The Phillips Curve 2. . . . raises the price level . . . 1. An increase in the money supply increases aggregate demand . . . A AD2 B 4. . . . but leaves output and unemployment at their natural rates. 3. . . . and increases the inflation rate . . . P2

The Phillips Curve in the 1960s Inflation Rate (percent per year) 10 8 6 1968 4 1966 1967 2 1965 1962 1964 1961 1963 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent)

The Breakdown of the Phillips Curve Inflation Rate (percent per year) 10 8 6 1973 1970 1971 1969 4 1968 1972 1966 1967 2 1965 1962 1964 1961 1963 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent)

The Supply Shocks of the 1970s Inflation Rate (percent per year) 10 1981 1980 1975 1974 1979 8 1978 6 1977 1976 1973 4 1972 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent)

The Volcker Disinflation Inflation Rate (percent per year) 10 1980 1981 1979 A 8 1982 6 1984 1983 B 4 1987 C 1985 1986 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent)

The Greenspan Era 10 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Inflation Rate (percent per year) 10 8 6 1990 4 1991 1989 1984 1988 1985 1987 2001 1995 2000 1992 1993 2 1994 1986 1997 1996 1999 1998 2002 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent)

Deflation Debt Deflation Effects of Expected Deflation Deflation creates the opposite problem of inflation. As the value of the dollar increases, the cost of all debts enumerated in dollars goes up. This causes a real transfer of wealth from borrowers to lenders. Effects of Expected Deflation Expectations of future prices have an effect on how those prices fluctuate. If expectations of deflation (or inflation) are large enough, it can have real effects. If deflation leads to negative interest rates, no one will lend – This is a Liquidity Trap (Zero Boundary)