Phillips Curve Analysis Inflation & Unemployment Managing the short run trade-off

Inflation & Unemployment Natural rate of unemployment depends on features of labor market : Including: minimum-wage laws, the market power of unions, the effectiveness of job search, etc…. The inflation rate depends primarily on growth in the quantity of money (controlled by the Fed)

Short-Run Trade-Off between If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment

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

Phillips Curve relation to AD & AS Quantity of Output 0 SRAS (a) Aggregate Demand and Aggregate Supply Model Unemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level (b) The Phillips Curve Phillips curve AD 1 AD 2 (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

The Long-Run Phillips Curve In the 1960s, Friedman & Phelps concluded that inflation & unemployment are unrelated in long run –As a result, the long-run Phillips curve is vertical at full employment

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. 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases...

Phillips Curve & Long Run AS/AD Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level P AD 1 LRAS Long-run Phillips curve Aggregate Demand and Aggregate Supply Model Unemployment Rate 0 Inflation Rate The Phillips Curve raises the price level An decrease in Taxes increases Aggregate demand. A AD 2 B A but leaves output and unemployment at their natural rates and increases the inflation rate... P2P2 B

The Short-Run Phillips Curve In long run, expected inflation adjusts to changes in actual inflation The Fed’s ability to create unexpected inflation exists only in the short run –Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above anticipated

Unemployment Rate Unemployment Rate = Natural Rate - a ( Actual inflation – Expected inflation) Only when Actual inflation is above Expected can: Unemployment fall below natural rate

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

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