ECN 204 Chapter Notes - Chapter 16: Edmund Phelps, Phillips Curve, Paul Samuelson

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24 Apr 2012
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Wednesday April 4th, 2012
Chapter 16
The Short Run Tradeoff between Inflation and Unemployment
The Phillips Curve:
-Phillips curve: shows the short-run trade-off between inflation and unemployment
-1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment
in the U.K
-1960: Paul Samuelson & Robert Solow found a negative correlation between Canadian and U.S.
inflation & unemployment, named it “the Phillips Curve.”
Deriving the Phillips Curve:
-Suppose P = 100 this year
-The following graphs show two possible outcomes for next year:
Aggregate demand low, small increase in P (i.e., low inflation), low output, high unemployment
Aggregate demand high, big increase in P (i.e., high inflation), high output, low unemployment
The Phillips Curve: A Policy Menu?
-Since fiscal and monetary policy affects aggregate demand, the PC appeared to offer policymakers a
menu of choices:
low unemployment with high inflation
low inflation with high unemployment
anything in between
-1960s: U.S. data supported the Phillips curve; many believed the PC was stable and reliable
The Vertical 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 LRAS curve
-In the face of what many considered overwhelming evidence for the stability of the downward-sloping
Phillips curve, Friedman and Phelps (working separately) boldly asserted that any tradeoff would be
purely temporary
The Vertical Long-Run Phillips Curve:
-In the long run, faster money growth only causes faster inflation
-the greater the expansion of the money supply, the faster AD will shift to the right, resulting in a larger
increase in prices
Example: higher inflation
-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
Reconciling Theory and Evidence:
-Evidence (from ’60s):
PC slopes downward
-theory (Friedman and Phelps):
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