Pump Primer : Draw the long-run equilibrium in the AD/AS framework. Show what happens in the short run when AD increases Explain what happens in the long run. 34

Module Inflation and Unemployment: The Phillips Curve KRUGMAN'S MACROECONOMICS for AP* 34 Margaret Ray and David Anderson

Biblical Integration : We should always demonstrate a Christ-like love for all our neighbors and to love them as ourselves. The cycles of our economy can cause hardships in our families and communities. So, the question for us to examine is how can we make a difference? (See Duet.15:7-8)

What you will learn in this Module : What the Phillips curve is and the nature of the short-run trade-off between inflation and unemployment Why there is no long-run trade-off between inflation and unemployment Why expansionary policies are limited due to the effects of expected inflation Why even moderate levels of inflation can be hard to end Why deflation is a problem for economic policy and leads policy makers to prefer a low but positive inflation rate

The Short-Run Phillips Curve The Short-Run Phillips Curve We have seen that there is a short-run trade-off between unemployment and inflation—lower unemployment tends to lead to higher inflation, and vice versa. The key concept is that of the Phillips Curve.

The Short-Run Phillips Curve The Short-Run Phillips Curve When AD increases along the SRAS, the unemployment rate falls and the inflation rate rises (a movement from point a to point b below). When AD decreases along the SRAS, the unemployment rate rises and the inflation rate falls (a movement from point b to point a below). Note: A shift in AD will cause a movement along the SRPC.

The Short-Run Phillips Curve The Short-Run Phillips Curve This allows us to draw a downward sloping relationship between the unemployment rate and the inflation rate. This is known as the short-run Phillips curve. When SRAS increases along the AD, both the unemployment and inflation rates fall. This is seen as a downward shift of the SRPC.

The Short-Run Phillips Curve The Short-Run Phillips Curve When SRAS decreases along the AD, both the unemployment and inflation rates rise. This is seen as an upward shift of the SRPC. (Note: The SRPC can extend below the horizontal axis, but cannot extend to the left of the vertical axis.)

Inflation Expectations and the Short-Run Phillips Curve Inflation Expectations and the Short-Run Phillips Curve The expected rate of inflation is the rate of inflation that employers and workers expect in the near future. One of the crucial discoveries of modern macroeconomics is that changes in the expected rate of inflation affect the short-run trade-off between unemployment and inflation and shifts the short-run Phillips curve.

Inflation Expectations and the Short-Run Phillips Curve Inflation Expectations and the Short-Run Phillips Curve Workers care about future inflation. If inflation is expected to be high in coming months, wage contracts should reflect that expectation and nominal wages will be increased. In fact, both workers and employers will factor expected inflation into all wage and price contracts because nobody wants to lose purchasing power due to future inflation.

Inflation Expectations and the Short-Run Phillips Curve Inflation Expectations and the Short-Run Phillips Curve For these reasons, an increase in expected inflation shifts the short- run Phillips curve upward: the actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher. In fact, macroeconomists believe that the relationship between changes in expected inflation and changes in actual inflation is one-to- one. That is, when the expected inflation rate increases, the actual inflation rate at any given unemployment rate will increase by the same amount. Why?

Inflation Expectations and the Short-Run Phillips Curve Inflation Expectations and the Short-Run Phillips Curve Suppose inflation has been near zero for years, but gradually people begin to expect inflation of 3%. Nominal wages and other contracts begin to reflect a future increase of 3%. As these wages and other resource prices rise by 3%, actual inflation begins to rise from about zero to 3%. So inflation expectations translate into actual inflation rates.

Inflation Expectations and the Short-Run Phillips Curve Inflation Expectations and the Short-Run Phillips Curve Higher inflation expectations shift the SRPC upward. At any level of unemployment, inflation will be that much higher. Of course this works in reverse. Lower inflation expectations shift the SRPC downward.

Inflation and Unemployment in the Long Run Most macroeconomists believe that there is, in fact, no long-run trade-off between lower unemployment rates and higher inflation rates. That is, it is not possible to achieve lower unemployment in the long run by accepting higher inflation.

Inflation and Unemployment in the Long Run Assume the economy is currently in long-run equilibrium and real GDP is at the level of full employment. The unemployment rate at full- employment is 5% and because the economy is in LR equilibrium, inflation is zero. This is seen as point A on SRPC0.

The Long-Run Phillips Curve The Long-Run Phillips Curve

Inflation and Unemployment in the Long Run Suppose now the government increases AD through either expansionary fiscal or monetary policy. AD shifts right, the unemployment rate falls to 3% but inflation rises to 2%. This is point B on SRPC0.

The Long-Run Phillips Curve The Long-Run Phillips Curve

Inflation and Unemployment in the Long Run Eventually inflation expectations adjust to 2% and nominal wages rise by 2%. The SRAS shifts upward to long-run equilibrium and so does the SRPC. What if the government attempts to keep unemployment at 3%? Before too long, this will cause more inflation to 4%, shifting the SRPC up to SRPC1.

The Long-Run Phillips Curve The Long-Run Phillips Curve

Inflation and Unemployment in the Long Run Instead, if the government allows the economy to adjust to an inflation rate of 2%, eventually the economy returns to full employment at unemployment of 5% and new inflation of 2%. This is point C on SRPC1. As AD shifts to the right or left in the short run, eventually the economy returns to an unemployment rate of 5% and possibly a higher, or lower, rate of inflation.

The Long-Run Phillips Curve The Long-Run Phillips Curve If we connect long-run points like points A and C, we can draw a long-run Phillips curve (LRPC). An unemployment rate of 3% will cause inflation to accelerate. The unemployment rate at which inflation does not change over time— 5% in the graph above, is known as the non-accelerating inflation rate of unemployment, or NAIRU for short.

The Long-Run Phillips Curve The Long-Run Phillips Curve Keeping the unemployment rate below the NAIRU leads to ever-accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long-run trade-off between unemployment and inflation.

The Natural Rate of Unemployment, Revisited The Natural Rate of Unemployment, Revisited Recall the concept of the natural rate of unemployment, the portion of the unemployment rate unaffected by the swings of the business cycle. Now we have introduced the concept of the NAIRU. How do these two concepts relate to each other? The answer is that the NAIRU is another name for the natural rate. The level of unemployment the economy “needs” in order to avoid accelerating inflation is equal to the natural rate of unemployment.

The Costs of Disinflation The Costs of Disinflation An effort to reduce unemployment below NAIRU will cause inflation. What about an effort to reduce inflation? The government must create a situation, with contractionary fiscal/monetary policy, where the unemployment rate is above NAIRU. This induced recession, should decrease the inflation rate to the point where the SRPC shifts downward. Once inflation is under control, the economy can adjust back to the NAIRU. This process of disinflation is painful because of a period of high unemployment.

The Costs of Disinflation The Costs of Disinflation

Deflation Why is deflation a problem? And, why is it hard to end? A. Debt Deflation Due to the falling price level, a dollar in the future has a higher real value than a dollar today. So lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises. What do you expect borrowers to do? Cut back on spending. So, weak spending causes deflation, which causes less spending, which causes deflation….

Deflation B. Effects of Expected Deflation We have already seen that interest rates are affected by inflation expectations. What about deflation? Nominal rate = real rate + expected inflation Suppose the rr=2% and expected inflation = 3%, then the nominal rate = 5%. But what if there is prolonged deflation and expected inflation is -2%, the nominal rate is 0%.

Deflation Interest rates cannot fall below 0%, there is a zero bound. So deflation creates a situation where lenders receive nominal interest rates that approach zero. Lending will stop. If the economy is extremely depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective. The Fed can’t lower the interest rate lower than 0%!! This kind of deflation can cause an economy to languish for a very long time. This is referred to as the liquidity trap.