Contractionary Monetary Policy In the Long-run - The Phillips Curve Shifts Downward Inflation Rate Unemployment As the Fed moves the economy to point F and keeps it there for some time, the public will eventually come to expect 3% inflation in the future. The built-in expected inflation rate will fall and the Phillips curve will shift downward to PCexpected inflation = 3%. The economy will move to point G in the long run, with unemployment at the natural rate and an actual inflation rate equal to the expected rate of 3% Pcexpected inflation = 6% E 6% Pcexpected inflation = 3% UN G F 3% U1

Expansionary Monetary Policy The Phillips Curve Shifts Upward Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point H and keeps it there for some time, the public will eventually come to expect 9% inflation in the future. The expected inflation rate will rise and the Phillips curve will shift upward to PCexpected inflation = 9%. The economy will move to point J in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 9%. Inflation Rate Unemployment Pcexpected inflation = 9% Pcexpected inflation = 6% H J 9% U2 E 6% UN

Expectations and Ongoing Inflation In the Long run there is no tradeoff Unemployment always returns to its natural rate Long-run Phillips curve A vertical line In the long run, unemployment must equal its natural rate Regardless of the rate of inflation

Long-Run Phillips Curve The Long-Run Phillips Curve Inflation Rate Unemployment PCexpected inflation = 9% Long-Run Phillips Curve Starting at point E with 6% inflation, the Fed can choose unemployment at the natural rate with either a higher rate of inflation (point J ) or a lower rate of inflation (point G ). But points off of the vertical line are not sustainable in the long run. PCexpected inflation = 6% H J 9% PCexpected inflation = 3% U2 E 6% UN G F 3% U1