The Phillips Curve Unemployment vs. Inflation Managing the short run trade-off

Full Employment & Inflation Full Employment rate depends on features of a labor market: Including: minimum-wage laws, market power of unions, effectiveness of job search (think internet) , & other labor laws etc…. In USA = 4.0% In France = 8.0% Inflation rate depends on growth in the quantity of money Supply of money is controlled by the Federal Reserve creates demand-pull inflation

Short Run Trade Off: Fiscal Policy Expansionary => ↑ AD => unemployment falls but inflation ↑ Contractionary =>↓ AD => inflation falls but unemployment ↑ LRAS1 Price Level Real GDP SRAS1 AS/AD Model Conclusion There is a short run trade off between: inflation & unemployment 2) There is no long run relationship…. AD2 --------------- P2 Y2 E2 ------------- AD1 P1 --------- E1 Y1

Short Run Phillips Curve (SRPC) % Inflation You can lower unemployment by creating ↑ inflation (in short run) Rate SRPC 3% B 6 4% A 2 % Unemployment Rate

SRAS & SRPC 1) If AD ↑ => Move upward SRAS => move upward SRPC 2) If SRAS shifts => SRPC shifts in the opposite direction AS/AD Model Short Run Phillips Curve Price LRAS Inflation Level SRAS AD2 Rate SRPC AD1 (R-GDP is 8,000) B 3% 6% 8,000 (unemployment is 3%) 106 B 7,500 102 A (R-GDP is 7,500) A 4% 2% Real GDP Unemployment (full unemployment is 4%) or Output Rate

The Long-Run Phillips Curve In the 1960s, Friedman & Phelps concluded that inflation & unemployment are unrelated in long run Inflation is only related to the Quantity Of Money Federal Reserve controls money supply Therefore, the Long-Run Phillips curve is vertical at full employment level

The Long-Run Phillips Curve Inflation LRPC Rate B High inflation 1. When the Fed increases Money supply The rate of inflation rises 2. . . . but unemployment remains at its natural rate in the long run. Low inflation A Natural rate of Unemployment unemployment Rate

Graphing Phillips Curves Phillips Curves are drawn on one graph If AS/AD is @ full potential => Phillips curves @ full employment Point A on both graphs Inflationary or Recessionary Gaps will follow AS/AD shifts B = inflationary gap AS/AD Model Phillips Curve Model Price LRAS Inflation LRPC Level AD2 8,000 (unemployment is 3%) 106 B SRAS Rate SRPC AD1 (R-GDP is 8,000) B 3% 6% 7,500 102 A (R-GDP is 7,500) A 4% 2% Real GDP Unemployment (full unemployment is 4%) or Output Rate

Phillips Curve Summary Short Run => inflation increases both R-GDP & employment Long Run => inflation does not impact R-GDP or employment Conclusion: Fiscal Policy not helpful in the long run! (should focus on shifting PPF!)

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