1. Inflation and Unemployment: The Phillips Curve Can Governments Lower Unemployment at No Cost?

2. The Short-Run Phillips Curve Inflation rate Unemployment rate 0 When the unemployment rate is low, inflation is high Short-run Phillips curve, SRPC When the unemployment rate is high, inflation is low

3. The Short-Run Phillips Curve and Supply Shocks Inflation rate Unemployment rate 0 A negative supply shock shifts SRPC up A positive supply shock shifts SRPC down SRPC 0 SRPC 1 SRPC 2

4. Expected Inflation and the Short-run Phillips Curve Inflation rate Unemployment rate 0 SRPC shifts up by the amount of the increase in expected inflation SRPC 0 SRPC 3 4% -2% 2% -6% -4% 6% 8% 10% 7 42 9 86 53 1 10 3% 1% 5% 7% 9% -1% -5% -3%

5. The NAIRU and the Long-Run Phillips Curve Inflation rate Unemployment rate 0 SRPC 0 4% -2% 2% -6% -4% 6% 8% 10% 7 42 9 86 53 1 10 3% 1% 5% 7% 9% -1% -5% -3% E0E0 Suppose the government attempts to push unemployment down (say to 5%), at the cost of higher inflation. What will happen?

6. E2E2 Positive Demand Shocks: Short-Run and Long-Run Effects 1. A positive demand shock occurs (in this case, government spends more or cuts taxes)… AD 2 AD 1 Aggregate Price Level Real GDP Y1Y1 Y2Y2 P1P1 P2P2 E1E1 LRAS Inflationary gap Potential output 2. …which increases the aggregate price level and aggregate output. SRAS 1 This leads to lower unemployment in the short run… Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?

7. A The NAIRU and the Long-Run Phillips Curve Inflation rate Unemployment rate 0 SRPC 0 4% -2% 2% -6% -4% 6% 8% 10% 7 42 9 86 53 1 10 3% 1% 5% 7% 9% -1% -5% -3% E0E0 Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen? What happens if the government continues on this course (trying to force down unemployment with higher inflation)? What effect did the government’s manipulation of AD have on the SRPC?

8. E2E2 Positive Demand Shocks: Short-Run and Long-Run Effects 1. A positive demand shock occurs (in this case, government spends more or cuts taxes)… AD 2 AD 1 Aggregate Price Level Real GDP Y1Y1 Y2Y2 P1P1 P2P2 E1E1 LRAS Inflationary gap Potential output 2. …which increases the aggregate price level and aggregate output. SRAS 2 SRAS 1 3. …until an eventual rise in nominal wages in the long run causes a negative supply shock. E3E3 P3P3 This leads to lower unemployment in the short run… …and moves the economy back to potential output. This decreases short-run aggregate supply Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?

9. E2E2 A The NAIRU and the Long-Run Phillips Curve Inflation rate Unemployment rate 0 SRPC 0 4% -2% 2% -6% -4% 6% 8% 10% 7 42 9 86 53 1 10 3% 1% 5% 7% 9% -1% -5% -3% SRPC 2 E0E0 Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen? What happens if the government continues on this course (trying to force down unemployment with higher inflation)? What effect did the government’s manipulation of AD have on the SRPC? Consumers build-in their expectations for inflation, and unemployment returns to its former levels. So what if the government tries again?

10. E2E2 Positive Demand Shocks: Short-Run and Long-Run Effects 1. In Round 2, another positive demand shock occurs (through more government spending) but now from the already higher price level... AD 2 AD 1 Aggregate Price Level Real GDP Y1Y1 Y2Y2 P1P1 P2P2 E1E1 LRAS Inflationary gap Potential output 2. …which increases the aggregate price level and aggregate output. SRAS 2 SRAS 1 3. …until an eventual rise in nominal wages in the long run causes a negative supply shock. E3E3 P3P3 This leads to lower unemployment in the short run… …and moves the economy back to potential output. This decreases short-run aggregate supply

11. E4E4 E2E2 C B A The NAIRU and the Long-Run Phillips Curve Inflation rate Unemployment rate 0 Nonaccelerating inflation rate of unemployment, NAIRU SRPC 0 SRPC 4 4% -2% 2% -6% -4% 6% 8% 10% 7 42 9 86 53 1 10 3% 1% 5% 7% 9% -1% -5% -3% SRPC 2 Long-run Phillips curve, LRPC E0E0 Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen? What happens if the government continues on this course (trying to force down unemployment with higher inflation)? What effect did the government’s manipulation of AD have on the SRPC? Consumers build-in their expectations for inflation, and unemployment returns to its former levels. So what if the government tries again?

12. Phillips Curve Questions Draw a graph AND EXPLAIN what would happen to SRPC in the following scenarios: 1.Government increases spending 2.The price of crude oil and most energy sources increase 3.Inflation expectations rise from 3% to 6% 4.The Fed increases interest rates with contractionary monetary policy 5.Inflation expectations fall from 5% to 2% 6.The government increases income taxes 7.What happens in the LONG RUN in Question #1?