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Chapter 16

Chapter 16 - The Short Run Tradeoff between Inflation & Unemployment

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Ryerson University
ECN 204
Eric Kam

Wednesday April 4 , 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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