ECON 105 Chapter Notes - Chapter 16: Phillips Curve, Money Supply, Monetary Policy

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15 Aug 2016
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Ch. 16 – Short-Run Trade-Off Between Inflation and Unemployment
- Phillips curve = shows SR trade-off b/t inflation & unemployment
 idea originated in 1958 when AW Phillips showed neg relationship b/t
unemployment & nominal wage growth in UK
 shows combos of inflation & unemployment that arise in SR due to shifts in
AD
 low AD, low inflation, high unemployment
- in money supply, in gov spending, ↓ ↓ in tax all lower AD
 high unemployment & low inflation
- in LR, Phillips curve is vertical
 occurs at natural rate of unemployment
- in LR, AS vertical too
in AD leads to in price level and has no effect on output↑ ↑
 occurs at natural rate of output
- in LR, in money supply growth rate causes in inflation↑ ↑
- in LR, expected inflation adjusts to change in actual inflation, SR Phillips curve
shifts
- SR Phillips curve equation:
u =
- in SR, economy moves along SRPC
 inflation and unemployment ↑ ↓
- in LR, expected inflation and as a result SRPC shifts up
 expected inflation and actual inflation both high, unemployment back to
natural rate
- natural-rate hypothesis = claim that unemployment eventually returns to natural
rate, regardless of inflation rate
- policy implications
 policymakers can choose inflation & unemployment in SR by controlling
AD but not in LR no trade-off
- supply shock = event that directly affects firms’ costs of production & prices they
charge, shifting AS & PC
 adverse supply shock leads to inflation & unemployment (i.e. oil crisis)↑ ↑
 favourable supply shock leads to inflation & unemployment (i.e. ↓ ↓
technological progress)
- when central bank pursues contractionary monetary policy to inflation, economy
moves along SRPC to a point w/ lower inflation & higher unemployment
 economy suffers thru time w/ high unemployment & low output
- sacrifice ratio = # of % pts of 1 yr’s output lost in process of inflation by 1 % point
 need to know 1) how change in inflation affects unemployment (from PC)
2) how change in unemployment affects output (from Okun)
- Okun’s law = # of % points output falls when unemployment rate by 1 % point
- if gov makes credible commitment to policy of low inflation, ppl would be rational
to lower expectations of inflation immediately
 SRPC shift down & cost of reducing inflation much lower
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