1 the phillips curve and the role of expectations
TRANSCRIPT
Copyright © 2004 South-Western
35 The Short-Run
Tradeoff between
Inflation and
Unemployment
Copyright © 2004 South-Western
Unemployment and Inflation
• The natural rate of unemployment depends on
various features of the labor market.
• Examples include minimum-wage laws, the
market power of unions, the role of efficiency
wages, and the effectiveness of job search.
• The inflation rate depends primarily on growth
in the quantity of money, controlled by the Fed.
Copyright © 2004 South-Western
Unemployment and Inflation
• Society faces a short-run tradeoff between
unemployment and inflation.
• 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.
Copyright © 2004 South-Western
THE PHILLIPS CURVE
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.
The Phillips Curve
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Phillips curve
4
B 6
7
A 2
Copyright © 2004 South-Western
The Phillips Curve and AS-AD
Quantity
of Output
0
Short-run
aggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate (percent)
0
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
(output is
7,500)
A
7
2
8,000
(unemployment
is 4%)
106 B
(unemployment
is 7%)
7,500
102 A
Copyright © 2004 South-Western
Copyright © 2004 South-Western
Short-Run Phillips Curve
• The Phillips curve seems to offer policymakers
a menu of possible inflation and unemployment
outcomes.
• But…
Copyright © 2004 South-Western
The Long-Run Phillips Curve
• In the 1960s, Friedman and Phelps concluded
that inflation and unemployment are unrelated
in the long run.
• As a result, the long-run Phillips curve is vertical at
the natural rate of unemployment.
• Monetary policy could be effective in the short run
but not in the long run.
The Long-Run Phillips Curve
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate Long-run
Phillips curve
B High
inflation
Low
inflation
A
2. . . . 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 . . .
Copyright © 2004 South-Western
The Phillips Curve and AS-AD
Quantity
of Output
Natural rate
of output
Natural rate of
unemployment
0
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
0
Inflation
Rate
(b) The Phillips Curve
2. . . . raises
the price
level . . .
1. An increase in
the money supply
increases aggregate
demand . . .
A
AD2
B
A
4. . . . but leaves output and unemployment
at their natural rates.
3. . . . and
increases the
inflation rate . . .
P2 B
Copyright © 2004 South-Western
Copyright © 2004 South-Western
Expectations and the SRPC
• Expected inflation measures how much people
expect the overall price level to change.
Copyright © 2004 South-Western
Expectations and the SRPC
• In the 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 the anticipated rate.
Copyright © 2004 South-Western
Expectations and the SRPC
Natural rate of unemployment - a Actual inflation
Expected inflation
Unemployment Rate =
How Expected Inflation Shifts the SRPC
Unemployment
Rate
0 Natural 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 . . .
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
C B
A
Copyright © 2004 South-Western