The Phillips Curve What relationship is it showing us? What determines Short Run vs Long Run? What is the Rational Expectations Theory?

Assume Natural Unemployment& Expected Inflation are constant Short Run Phillips Curve shows relationship between Unemployment & Inflation - Pt. A is where Actual #’s = Natural and Expected (Full Employment) Along the curve, unemployment = inflation & inflation = unemployment Movement along AS is equivalent to Movement along SRPC SRPC Inflation Rate Unemployment Rate Natural Unemploy = 6% Expected Inflation = 3% 6% 3% A

Movement along AS is equivalent to AD1 AD AD1 Real Money Wage rate = fixed so price level affects Real Wage Rate At Full employment:RGDP=PGDP & Unemploy% =Nat. Unemploy% Inflation Rate = % change in Price Level Movement along AS is equivalent to Movement along SRPC

Why the Phillips Curve instead of AS? Focuses on 2 Gov’t Policy Targets – Unemployment and Inflation 2. AS is more volatile shifting when PGDP and/or Wage Rates change(could be a daily thing)- SRPC is still variable, but only shifts when Natural Unemployment or Expected Inflation change

Do these now with a partner using the table below as reference Practice Problems Do these now with a partner using the table below as reference Calculate the inflation rate for each possible outcome What are the expected price level and expected inflation rate in 2014 Plot the SRPC for 2014, mark the points A,B,C,D,E that correspond to the table.

Short Run vs. Long Run Phillips Short Run PC shows the trade-off between unemployment and inflation when expected inflation and natural unemployment are constant Changes in expected inflation and natural unemployment change the short-run tradeoff relationship (shifts in SRPC), while changes in the expected inflation rate lead to the Long Run Phillips Curve The LRPC shows the relationship between inflation and unemployment when the economy is at full employment and full employment = natural unemployment.

Long Run Phillips Curve In the Long Run: Full Employment = Natural Unemployment (Like LRAS where Potential GDP= RGDP) BUT: Inflation can be at any rate depending on money growth rate so LRPC is a vertical line where Unemployment = Natural Unemployment

Expected Inflation Rate Expected Inflation = change in price level that is expected- adjustments will be made to maintain real wage rates & employment levels (thus the vertical curve for LRPC) A change in expected inflation rates would shift the SRPC, but it will intersect the LRPC at that new expected inflation rate

Natural Rate Hypothesis Proposition that when inflation rate changes the unemploy. rate changes temporarily while the economy adjusts, but will return to natural unemployment rate If the natural unemployment rate changes, both the SRPC and the LRPC will shift accordingly

Do these now with a partner using the table below as reference Practice Problems Do these now with a partner using the table below as reference Copy the curves into your notes – label the SRPC and the LRPC. What is the Expected Inflation Rate, What is the Natural Unemployment Rate? If the expected inflation rate increases to 7.5%, show the new SRPC and LRPC. If the natural unemployment rate increases to 8%, show the new SRPC and LRPC. If AD starts to grow more rapidly and inflation hits 10%, how do unemployment and inflation change?

Rational Expectations Theory Economists try to predict future inflation rate based on the economy and economic policies, a combination of AD/AS, Money Supply, Inflation, GDP Growth Rate etc, but the biggest factor is the Fed’s Monetary Policy The Fed can implement policies that target inflation and hope to keep the expected inflation low, but unemployment is harder to target since it is constrained by the natural unemployment rate The most successful policies are those that target inflation

Targeting the Unemployment Rate

Do these now with a partner using the graph below as reference Practice Problems Do these now with a partner using the graph below as reference Suppose that the current inflation rate = 5%, and the Fed announces that it will slow the money growth rate so that inflation next year will fall to 2.5%. No one believes the Fed, an inflation is expected to be 5%, how will the Fed’s action affect inflation and unemployment? Everyone believes the Fed, explain the effect of the Fed’s action on inflation and unemployment. No one believes the Fed, but the Fed maintains its policy and keeps inflation at 2.5% for many years, explain the effects on inflation and unemployment.