The Short-Run Tradeoff between Inflation and Unemployment Chapter 33 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida

Unemployment and Inflation u Short run fluctuations in unemployment are caused by changes in the level of real GDP uInflation can be caused by changes in demand or changes in supply and generally follows the level of GDP. uSevere inflation is almost always caused by excessive increases in the money supply.

The Phillips Curve The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve... Unemployment Rate (percent) 0 Inflation Rate (percent per year) 4 B 6 A 7 2 Phillips curve

Output, employment and price level uThe greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. uA higher level of output results in a lower level of unemployment.

How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply... Phillips curve 0 (b) The Phillips Curve Inflation Rate (percent per year) Unemployment Rate (percent) 0 (a) The Model of AD and AS Price Level Low AD High AD B 4 6 (output is 8,000) A 7 2 (output is 7,500) A 7, (unemployment is 7%) B 8, (unemployment is 4%) Short-run AS

The Phillips Curve and the Natural Rate of Unemployment u The natural rate of unemployment depends on various features of the labor market. u Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. u In the short-run the natural rate of unemployment is constant. u The Long-run Phillips curve illustrates the Natural rate of unemployment.

Unemployment Rate 0 Inflation Rate Long-run Phillips Curve A C B Natural Rate of Unemployment 6 % 4 % 5 % 3 % 7 % Short run & Long run Phillips Curve 2 %