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ECON1000 CH. 16.docx

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Carleton University
ECON 1000
Nick Rowe

The Phillips Curve: A Policy Menu? • Since fiscal and monetary policy affect aggregate demand, the PC appeared to offer policymakers a menu of choices: o Low unemployment with high inflation o Low inflation with high unemployment o Anything in between • In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run o The long-run Phillips curve is vertical at the natural rate of unemployment o Monetary policy could be effective in the short run, but not in the long run The Vertical Long-Run Phillips Curve • Natural-rate hypothesis: the claim that unemployment eventually returns to its normal rate or "natural" rate, regardless of the inflation rate • Based on the classical dichotomy and the vertical LRAS curve Reconciling Theory and Evidence • Evidence from 60s o PC slopes downward • Theory (Friedman and Phelps' work) o PC is vertical in the long run • To bridge the gap between theory and evidence, Friedman and Phelps introduced a new variable: expected inflation--a measure of how much people expect the price level to change The Phillips Curve Equation U rate = natural rate of U - a(actual inflation - expected inflation) Short run: federal government can reduce u-rate below the natural u-rate by making inflation greater than expected Long run: expectations catch up to reality, unemployment rate goes back to natural u-rate, whether inflation is high or low How Expected Inflation Shifts the PC Another PC Shifter: Supply Shocks • Supply schock: o An event that directly alters firms' costs and prices, shifting the AS and PC curves • Example: large increase in oil prices • In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwise prices of petroleum o Fight the unemployment battle by expanding aggregate demand and accelerating inflation o Fight inflation by contracting aggregate demand and endure even high unemployment How an Adverse Supply Shock Shifts the PC The 1970s Oil Price Shocks The BOC chose to accommodate the first shock in 1973 with faster money growth. This resulted in higher expected inflation, which shifted PC. In 1979, oil prices surged again, worsening the BOC tradeoff. The Cost of Reducing Inflation • Disinflation: a reduction in the inflation rate • To reduce inflation: BOC must slow the rate of money growth, which reduces aggregate demand • Short run: output falls and unemployment rises • Long run: output & unemployment return to their natural rates Disinflationary Monetary Policy The Cost of Reducing Inflation • Disinflation requires enduring a period of high unemployment and low output • Sacrifice
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