1. The Phillips Curve

2. Intro to Phillips Curve  There is a short-run trade-off between unemployment and inflation  Lower unemployment leads to higher inflation  Higher unemployment leads to lower inflation This is inverse relationship is represented by the Phillips Curve!

3. Short Run Phillips Curve

4. Short-Run Phillips Curve  Demand shocks result in movement along SRPC  When AD increases along SRAS, unemployment rate ↓ and inflation rate ↑  When AD decreases along SRAS, unemployment rate ↑ and inflation rate ↓  Supply shocks result in shift of SRPC  When SRAS increases along AD, both unemployment and inflation rates ↓ (downward shift)  When SRAS decreases along AD, both unemployment and inflation rates ↑(upward shift)  SRPC can extend below the horizontal axis (in times of deflation)

5. Inflation Expectations  Expected rate of inflation: rate of inflation employers and workers expect in the near future  Affect short-run trade-off between unemployment and inflation  Matters because no one wants to lose purchasing power due to future inflation  An increase in expected inflation shifts SRPC upward  Relationship between changes in expected inflation and actual is one-to-one (will rise by the same amount)

6. Long-Run Phillips Curve  Most macroeconomists believe there is no long-run trade-off between lower unemployment rates and higher inflation rates.  It is not possible to achieve lower unemployment in the long run by accepting higher inflation. Let’s see why!

8. Natural Rate of Unemployment Revisited  Non-accelerating inflation rate of unemployment: represents the unemployment rate at which inflation does not change over time (NAIRU)  Keeping unemployment below NAIRU leads to ever-accelerating inflation—cannot be maintained  NAIRU is another name for natural rate  Level of unemployment needed in order to avoid accelerating inflation

9. Long Run Phillips Curve  Vertical curve set at NAIRU  The relationship between unemployment and inflation in the long run, after expectations of inflation have had time to adjust to experience.  Proves there are limits to expansionary policies when already at full employment

10. Costs of Disinflation  Recall: disinflation is the process of bringing down inflation that has become embedded in expectations  To bring down inflation, contractionary policies raise unemployment above the natural rate for an extended period  As a result, the economy loses potential output

11. Deflation  Value of money rising over time (fall in price level)  Debt deflation results from borrowers cutting back their spending because of the additional burden of repaying money that is worth more, reducing aggregate demand – which leads to more deflation, which can spiral out of control

12. Effects of Expected Inflation  Fisher Effect shows that interest rates are impacted by expected inflation one-to-one  In case of deflation, interest rates will fall – but they are zero bound – which creates a limit for monetary policy  Interest rate too low leaves no incentive to save and a credit freeze  Liquidity trap results from sharp reduction in demand for loanable funds, causing interest rates to fall so low that monetary policy is ineffective