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Chapter 16 The Short Run Tradeoff between Inflation and Unemployment

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Ryerson University
ECN 204
Paul Missios

Chapter 16: The Short Run Tradeoff between Inflation and Unemployment Phillips Curve: a curve that shows the short-run tradeoff between inflation and unemployment Origins of the Phillips Curve Negative Correlation: Phillips showed that years with low unemployment tend to have high inflation and years with high unemployment tend to have low inflation. Aggregate Demand, Aggregate Supply, and the Phillips Curve -The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate demand curve move the economy along the short run aggregate supply curve Example: Suppose P=100 this year. There are two possible outcomes: A: Aggregate demand is low, small increase in P (low inflation) and low output, high unemployment B: Aggregate demand is high, big increase in P (high inflation) and high output, low unemployment -If aggregate demand next year is low (slow money growth) then outcome A will occur. P = 103 next year, so the inflation rate from this year to next equals 3%. Output Y1 is relatively low, so unemployment is relatively high at 6%. -If aggregate demand next year is high (rapid money growth) then outcome B will occur. P=105 next year, so the inflation rate from this year to next equals 5%. Output Y2 is higher so unemployment is lower at 4%. The Phillips Curve: A Policy Menu? -Since fiscal and monetary policy affect aggregate demand, the Phillips curve appeared to offer policymakers a menu of choices:  Low unemployment with high inflation  Low inflation with high unemployment  Anything in betweenShifts in the Phillips Curve: The Role of Expectation The Long-Run Phillips Curve 1968: Milton Friedman and Edmund Phelps argued that the tradeoff was temporary. Natural-rate Hypothesis: the claim that unemployment eventually returns to its normal or “natural rate” regardless of the inflation rate – Based on the classical dichotomy and the vertical Long run aggregate supply curve. -The greater the expansion of money supply, the faster AD will shift to the right resulting in increases in prices therefore higher inflation. But this higher inflation will not produce lower unemployment: in the long run, unemployment always goes to its natural rate whether inflation is high or low. In the long run, faster money growth only causes faster inflation. The Meaning of “Natural” -Monetary policy cannot influence the natural rate of unemployment but other policies can. Labor- market policies such as minimum wage laws, employment insurance, and job training programs affect the natural rate of unemployment. A policy change that reduced the natural rate of unemployment would shift the long run Phillips curve to the left. The long run aggregate supply curve will shift to the right because lower unemployment means more goods and services, and quantity of g&s supplied would be larger at any given price level. The economy could then enjoy lower unemployment and higher output for any given rate of money growth and inflation Reconciling Theory and Evidence Phillips theory is that PC slopes downward. Friedman and Phelps theory states that PC is vertical in the long run. -To bridge the gap between theory and evident, Friedman and Phelps introduced a new variable: Expected Inflation: a measure of how much people expect the price level to change Short Run Phillips Curve Short Run: BOC can reduce unemployment rate below the natural u-rate by making inflation greater than expected Long Run: Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low -The coefficient a is a positive number that measures the relationship between unexpected inflation and deviations of unemployment from its natural rate. A 1% increase in inflation causes the unemployment rate to fall by a (for given values of the natural rate and expected inflation) -If the BOC wants to reduce unemployment below the natural rate, it has to surprise people with higher than anticipated inflation. This result will be lower unemployment- but only until people adjust theirexpectations to the new reality of higher inflation. Eventually, expectations catch up with reality, so they adjust their expectations upwards. How Expected Inflation shifts the Phillips Curve -When people adjust their inflation
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