 Stabilization policies (fiscal and monetary) are applied to affect inflation and unemployment  The difficulty in stabilization is that inflation and unemployment generally have an inverse relationship  EXAMPLE:  If there is economic expansion and there is increased aggregate demand, then equilibrium price and quantity increase  This results in more jobs (to create a higher output/quantity)  Thus, economic expansion that causes inflation is called demand-pull inflation Inflation & Unemployment

Demand-Pull Inflation AS a b During expansionary times, aggregate demand increases (shift of aggregate demand curve from AD 0 to AD 1 ) Result: price level rises from point a to point b Increased demand pulls up prices Real GDP (2002 $ billions)

 Under the assumption that there is a fixed and predictable inverse relationship between unemployment and inflation, economist A. W. H. Phillips created a curve which expresses this relationship The Phillips Curve

 Phillips Curve  Expresses inverse relationship between unemployment and inflation  When economy moves from A to B (due to expansionary stabilization policies), inflation increases, unemployment decreases The Phillips Curve Cont’d  Contractionary policies cause the economy to move from point A to a point right of A

 1960 – 1972: inflation and unemployment displayed a trend that clearly followed the shape of a Phillips Curve  1973 – 1982: inflation and unemployment were both higher than in the previous period, so the graph moved up and right  Example of STAGFLATION: combination of consistently low output (expanding unemployment) and rising inflation  An increase in input prices decreases a business’s output, reducing aggregate supply  Increased costs push price levels up: Cost-push inflation  1983 – 2010: there was a trend to lower inflation, but unemployment rates stayed high, so there was no clear Phillips Curve Shifts in the Phillips Curve

Cost-Push Inflation  Increased input prices cause businesses to decrease output  Resulting decrease in aggregate supply means a shift in the aggregate supply curve from AS 0 to AS 1  Result: price level is pushed up from point d to point c  Increased costs push up prices d c

 In recent years, the Bank has engaged in inflation targeting, a monetary policy program where a central bank keeps annual inflation within a given range  Bank of Canada keeps inflation between 1 % and 3 %  Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation  Price Level Targeting: a monetary policy goal of keeping overall price levels stable, or meeting a pre-determined price level target  The price level used as a barometer is the Consumer Price Index (CPI), or some similarly broad measure of cost inputs Targeting

 Economy is able to stabilize itself in the long-run  During an economic boom, output may be above the economy’s potential level  Unemployment is low, so workers bargain for higher wages  Wage hikes raise business costs, leading to a decrease in AS  Equilibrium moves back to economy’s potential output  Unemployment rises to its natural rate  During a recession, output may be below its potential, with a high unemployment rate  Unemployment causes a downward pressure on wages  Increase in AS boosts output back to potential level  Unemployment lowers to its natural rate Economy’s Self-Stabilizing Tendency

 Some economists see little need for government stabilization policy  they believe the economy adjusts quickly by itself to its potential output level  Many economists see the self-adjusting process as a slow one, which means that government stabilization policy can still play an important role in reducing the severity of the ups and downs in the business cycle Economy’s Self-Stabilizing Tendency