1. Inflation and Unemployment: The Phillips Curve
Lesson 35
Section 34

2. The Short-Run Phillips Curve
The Short-Run Phillips Curve shows the short run trade off between inflation and unemployment.
Quantity
of Output
Short-run
aggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate (percent)
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
7,500) A 7 2
8,000
(unemployment
is 4%)
106
is 7%)
7,500
102

3. Inflation and Unemployment in the Long-Run
The Long-Run Phillips Curve
The Natural Rate of Unemployment
To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation.
Nonaccelerating inflation rate of unemployment NAIRU
Employment higher than NAIRU causes inflation
The Costs of Disinflation
Deliberately higher levels of unemployment to bring inflation down
Quantity
of Output
Natural rate
of output
Natural rate of
unemployment
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
Inflation
(b) The Phillips Curve
raises
the price
level . . .
1. An increase in
the money supply
increases aggregate
demand . . . A
AD2 B
but leaves output and unemployment
at their natural rates.
and
increases the
inflation rate . . . P2

4. The Phillips Curve in the 1960s
Inflation Rate
(percent per year) 10 8 6
1968 4
1966
1967 2
1965
1962
1964
1961
1963 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

5. The Breakdown of the Phillips Curve
Inflation Rate
(percent per year) 10 8 6
1973
1970
1971
1969 4
1968
1972
1966
1967 2
1965
1962
1964
1961
1963 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

6. The Supply Shocks of the 1970s
Inflation Rate
(percent per year) 10
1981
1980
1975
1974
1979 8
1978 6
1977
1976
1973 4
1972 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

7. The Volcker Disinflation
Inflation Rate
(percent per year) 10
1980
1981
1979 A 8
1982 6
1984
1983 B 4
1987 C
1985
1986 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

8. The Greenspan Era 10 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Inflation Rate
(percent per year) 10 8 6
1990 4
1991
1989
1984
1988
1985
1987
2001
1995
2000
1992
1993 2
1994
1986
1997
1996
1999
1998
2002 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

9. Deflation Debt Deflation Effects of Expected Deflation
Deflation creates the opposite problem of inflation. As the value of the dollar increases, the cost of all debts enumerated in dollars goes up. This causes a real transfer of wealth from borrowers to lenders.
Effects of Expected Deflation
Expectations of future prices have an effect on how those prices fluctuate.
If expectations of deflation (or inflation) are large enough, it can have real effects.
If deflation leads to negative interest rates, no one will lend – This is a Liquidity Trap (Zero Boundary)