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UNIT 4

PART II

ECONOMICS
Prepared By Kunal Mojidra

THE SHORT-RUN TRADEOFF
BETWEEN INFLATION AND

UNEMPLOYMENT

UNEMPLOYMENT AND INFLATION
The natural rate of unemployment depends on various features of the labor market.  Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search.  The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.

EFM, Unit 4 Part II by KUNAL

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they can lower inflation.  If policymakers expand aggregate demand.UNEMPLOYMENT AND INFLATION Society faces a short-run tradeoff between unemployment and inflation. they can lower unemployment. but only at the cost of higher inflation.  EFM. Unit 4 Part II by KUNAL 4 .  If they contract aggregate demand. but at the cost of temporarily higher unemployment.

THE PHILLIPS CURVE  The Phillips curve illustrates the short-run relationship between inflation and unemployment. Unit 4 Part II by KUNAL B 2 A Phillips curve 0 4 7 Unemployment Rate (percent) 5 . Inflation Rate (percent per year) 6 EFM.

and the higher is the overall price level.AGGREGATE DEMAND. EFM. AGGREGATE SUPPLY. AND THE PHILLIPS CURVE  The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.  6 . the greater is the economy’s output.  A higher level of output results in a lower level of unemployment. Unit 4 Part II by KUNAL The greater the aggregate demand for goods and services.

Unit 4 Part II by KUNAL Short-run aggregate supply B A High aggregate demand Low aggregate demand Inflation Rate (percent per year) 6 B 106 102 A 2 Phillips curve 0 7.HOW THE PHILLIPS CURVE IS RELATED TO AGGREGATE DEMAND AND AGGREGATE SUPPLY (a) The Model of Aggregate Demand and Aggregate Supply Price Level (b) The Phillips Curve EFM.000 (unemployment (unemployment is 7%) is 4%) Quantity of Output 0 4 (output is 8.500 8.000) Unemployment 7 (output is Rate (percent) 7.500) 7 .

Unit 4 Part II by KUNAL 8 . EFM.SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS  The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

THE LONG-RUN PHILLIPS CURVE  In the 1960s. the long-run Phillips curve is vertical at the natural rate of unemployment.   As a result. Monetary policy could be effective in the short run but not in the long run. EFM. Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. Unit 4 Part II by KUNAL 9 .

THE LONG-RUN PHILLIPS CURVE Inflation Rate Long-run Phillips curve EFM. the rate of inflation increases . High inflation B Low inflation A 2. . but unemployment remains at its natural rate in the long run. . Unit 4 Part II by KUNAL 1. When the Fed increases the growth rate of the money supply. 0 Natural rate of unemployment Unemployment Rate 10 . . . .

B A 0 Natural rate of output Quantity of Output 0 Natural rate of unemployment Unemployment Rate 4. Unit 4 Part II by KUNAL Price Level P2 2. AD Inflation Rate Long-run Phillips curve 3. . Long-run aggregate supply 1.HOW THE PHILLIPS CURVE IS RELATED TO AGGREGATE DEMAND AND AGGREGATE SUPPLY (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve EFM. . . but leaves output and unemployment at their natural rates. . . An increase in the money supply increases aggregate B demand . . raises the price P level . and increases the inflation rate . . . . . . . A AD2 Aggregate demand. 11 . . . .

EFM. Unit 4 Part II by KUNAL In the long run. the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.  The Fed’s ability to create unexpected inflation exists only in the short run.EXPECTATIONS AND THE SHORT-RUN PHILLIPS CURVE  Expected inflation measures how much people expect the overall price level to change.   Once people anticipate inflation. expected inflation adjusts to changes in actual inflation. 12 .

actual inflation.EXPECTATIONS AND THE SHORT-RUN PHILLIPS CURVE Unemployment Rate = Expected Natural rate of unemployment . 13 . and expected inflation.a Actual inflation inflation  EFM. Unit 4 Part II by KUNAL This equation relates the unemployment rate to the natural rate of unemployment.

expected inflation rises. .HOW EXPECTED INFLATION SHIFTS THE SHORTRUN PHILLIPS CURVE 2. 0 Short-run Phillips curve with low expected inflation Unemployment Rate 14 Natural rate of unemployment . . . Expansionary policy moves the economy up along the short-run Phillips curve . Unit 4 Part II by KUNAL Inflation Rate B C Short-run Phillips curve with high expected inflation A 1. and the short-run Phillips curve shifts to the right. but in the long run. Long-run Phillips curve EFM. . .

THE NATURAL EXPERIMENT FOR THE NATURAL-RATE HYPOTHESIS The view that unemployment eventually returns to its natural rate.  15 . regardless of the rate of inflation. Unit 4 Part II by KUNAL The concept of a stable Phillips curve broke down in the in the early ’70s.  EFM. is called the natural-rate hypothesis. the economy experienced high inflation and high unemployment simultaneously.  Historical observations support the natural-rate hypothesis.  During the ’70s and ’80s.

Unit 4 Part II by KUNAL 8 6 1968 4 1967 1966 2 1962 1965 1964 1963 1961 16 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) .THE PHILLIPS CURVE IN THE 1960S Inflation Rate (percent per year) 10 EFM.

THE BREAKDOWN OF THE PHILLIPS CURVE Inflation Rate (percent per year) 10 EFM. Unit 4 Part II by KUNAL 8 6 1969 1968 1967 1973 1971 1970 1972 4 1966 2 1962 1965 1964 1963 1961 17 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) .

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS  Historical events have shown that the short-run Phillips curve can shift due to changes in expectations. 18 EFM. Unit 4 Part II by KUNAL .

EFM. An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment. Unit 4 Part II by KUNAL  Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. 19 .SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS  The  short-run Phillips curve also shifts because of shocks to aggregate supply.

. as a result.  . . . 20 EFM. the prices they charge.  This shifts the economy’s aggregate supply curve. the Phillips curve.SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS A supply shock is an event that directly alters the firms’ costs. Unit 4 Part II by KUNAL . and as a result. and. .

and raises the price level . . . B A 4. . giving policymakers a less favorable tradeoff between unemployment and inflation. Phillips curve. . Aggregate demand 0 Y2 Y 2. B A PC2 P 1. . An adverse shift in aggregate supply . . . . Unit 4 Part II by KUNAL AS2 Aggregate supply. . . AS Inflation Rate P2 3. . .AN ADVERSE SHOCK TO AGGREGATE SUPPLY (a) The Model of Aggregate Demand and Aggregate Supply Price Level (b) The Phillips Curve EFM. . lowers output . . P C Quantity of Output 0 Unemployment Rate 21 . .

Fight inflation by contracting aggregate demand and endure even higher unemployment. 22 .SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS  In the 1970s.  EFM. policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. Unit 4 Part II by KUNAL  Fight the unemployment battle by expanding aggregate demand and accelerate inflation.

Unit 4 Part II by KUNAL 1974 8 1979 1978 6 1973 1977 1976 4 1972 2 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) 23 .THE SUPPLY SHOCKS OF THE 1970S Inflation Rate (percent per year) 10 1980 1981 1975 EFM.

 24 EFM.  This reduces the quantity of goods and services that firms produce. Unit 4 Part II by KUNAL .THE COST OF REDUCING INFLATION To reduce inflation.  When the Fed slows the rate of money growth. it contracts aggregate demand.  This leads to a rise in unemployment. the Fed has to pursue contractionary monetary policy.

.DISINFLATIONARY MONETARY POLICY IN THE SHORT RUN AND THE LONG RUN Inflation Rate A 1. but in the long run. . . 25 . and the short-run Phillips curve shifts to the left. Unit 4 Part II by KUNAL Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation 0 Natural rate of unemployment Unemployment 2. . expected Rate inflation falls. . Long-run Phillips curve EFM. Contractionary policy moves the economy down along the short-run Phillips curve .

26 EFM. the economy moves down the short-run Phillips curve. Unit 4 Part II by KUNAL .THE COST OF REDUCING INFLATION To reduce inflation. The economy experiences lower inflation but at the cost of higher unemployment. an economy must endure a period of high unemployment and low output.    When the Fed combats inflation.

Unit 4 Part II by KUNAL An estimate of the sacrifice ratio is five. To reduce inflation from about 10% in 1979-1981 to 4% would have required an estimated sacrifice of 30% of annual output! 27 .THE COST OF REDUCING INFLATION The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.    EFM.

when forecasting the future. 28 EFM.RATIONAL EXPECTATIONS AND THE POSSIBILITY OF COSTLESS DISINFLATION  The theory of rational expectations suggests that people optimally use all the information they have. including information about government policies. Unit 4 Part II by KUNAL .

RATIONAL EXPECTATIONS AND THE POSSIBILITY OF COSTLESS DISINFLATION Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run.  29 EFM. Unit 4 Part II by KUNAL .  How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.

RATIONAL EXPECTATIONS AND THE POSSIBILITY OF COSTLESS DISINFLATION  The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated. Unit 4 Part II by KUNAL 30 . EFM.

THE VOLCKER DISINFLATION When Paul Volcker was Fed chairman in the 1970s. but at the cost of high employment (about 10 percent in 1983). Unit 4 Part II by KUNAL .  31 EFM.  Volcker succeeded in reducing inflation (from 10 percent to 4 percent). inflation was widely viewed as one of the nation’s foremost problems.

THE VOLCKER DISINFLATION Inflation Rate (percent per year) 10 1980 1981 A 1979 EFM. Unit 4 Part II by KUNAL 8 1982 6 1984 1987 4 C B 1983 1985 2 1986 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) 32 .

Unit 4 Part II by KUNAL .   In 1986. 33 EFM. OPEC members abandoned their agreement to restrict supply. This led to falling inflation and falling unemployment.THE GREENSPAN ERA  Alan Greenspan’s term as Fed chairman began with a favorable supply shock.

THE GREENSPAN ERA Inflation Rate (percent per year) 10 EFM. Unit 4 Part II by KUNAL 8 6 1990 1991 1989 1984 1988 1985 1987 2001 1995 1992 2000 1986 1997 1994 1993 1999 1998 1996 2002 4 2 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) 34 .

35 EFM.THE GREENSPAN ERA  Fluctuations in inflation and unemployment in recent years have been relatively small due to the Fed’s actions. Unit 4 Part II by KUNAL .