Copyright © 2006 Thomson Learning 35 The Short-Run Trade-Off between Inflation and Unemployment

Figure 1 The Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B 6 7 A 2 Copyright © 2004 South-Western

Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output 0 Short-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (percent) 0 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 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7, A Copyright © 2004 South-Western

Figure 3 The Long-Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve B High inflation Low inflation A but unemployment remains at its natural rate in the long run. Copyright © 2004 South-Western 1. When the central bank the growth rate of the money supply, the rate of inflation increases... increases

Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output Natural rate of output Natural rate of unemployment 0 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 0 Inflation Rate (b) The Phillips Curve raises the price level An increase in the money supply increases aggregate demand... A AD 2 B A but leaves output and unemployment at their natural rates and increases the inflation rate... P2P2 B Copyright © 2004 South-Western

Figure 5 How Expected Inflation Shifts the Short- Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short-run Phillips curve but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B A Copyright © 2004 South-Western

Figure 6 The Breakdown of the Phillips Curve Copyright © 2004 South-Western

Figure 7 An Adverse Shock to Aggregate Supply Quantity of Output 0 Price Level Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve and raises the price level... AS 2 Aggregate supply,AS A 1. An adverse shift in aggregate supply giving policymakers a less favourable trade-off between unemployment and inflation. B P2P2 Y2Y2 P A Y Phillips curve,PC lowers output... PC 2 B Copyright © 2004 South-Western

Figure 8 The Supply Shocks of the 1970s Copyright © 2004 South-Western

Figure 9 Disinflationary Monetary Policy in the Short Run and the Long Run Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve but in the long run, expected inflation falls, and the short-run Phillips curve shifts to the left. B C A Copyright © 2004 South-Western

Figure 10 The Thatcher Disinflation Copyright © 2004 South-Western