1. The Phillips Curve Unemployment vs. Inflation
Managing the short run trade-off

2. Employment & Inflation
Full Employment level depends on each country’s features of labor market:
Including: minimum-wage laws, the market power of unions, the effectiveness of job search (think internet) , & other labor laws etc….
In USA = 4.5%
Inflation rate depends on growth in the quantity of money
Supply of money is controlled by the Federal Reserve

3. Fiscal Policy: short run trade off
If policymakers ↑ aggregate demand, they can lower unemployment, but only at the cost of higher inflation
If they ↓ aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment

4. Short Run Phillips Curve
% Inflation
Rate
Short Run
Phillips curve 4 B 6 7 A 2
% Unemployment
Rate

5. Phillips Curve & SRAS Curve
Aggregate Demand & Aggregate Supply
The Phillips Curve
Price
Inflation
Level
SRAS
AD2
Rate
(percent
Phillips curve
per year)
AD1
(output is
8,000) B 4 6
8,000
(unemployment
is 4%)
106 B
(unemployment
is 7%)
7,500
102 A
(output is
7,500) A 7 2
Real GDP
Unemployment
or Output
Rate (percent)
If SRAS shifts => Short Run Phillips Curve shifts
(but in opposite direction)

6. 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
Milton Friedman

7. The Long-Run Phillips Curve
Inflation
Rate
Long-run
Phillips curve B
High
inflation
1. When the
Fed increases
Money supply
The rate of
inflation rises
but unemployment
remains at its natural rate
in the long run.
Low
inflation A
Natural rate of
Unemployment
unemployment
Rate

8. Phillips Curve & Long Run AS
The Phillips Curve
Aggregate Demand and Aggregate Supply Model
Price
Inflation
Long-run Phillips
Level
Rate
LRAS
curve
1. An decrease in
Taxes increases
Aggregate demand
. .
and
increases the
inflation rate . . .
AD2 P2 B B
raises
the price
level . . . A P A
AD1
Natural rate
Quantity
Natural rate of
Unemployment
of output
of Output
unemployment
Rate
but leaves output and unemployment
at their natural rates.

9. Conclusion
In long run, expected inflation adjusts to changes in actual inflation
So fiscal policy is not effective in lowering unemployment only in increasing inflation
Fed can only create unexpected inflation in short run
Once people anticipate inflation, they adjust.
Only way to get unemployment below the natural rate is for actual inflation to be above anticipated

10. Worksheet