ECN 111 Chapter 17 Lecture Notes

17.1 The Short-Run Phillips Curve

A. The Short-Run Phillips Curve
The short-run Phillips curve is a curve that shows the relationship between the inflation rate and
the unemployment rate when the natural unemployment rate and the expected inflation rate remain
constant.
1. The short-run Phillips curve is a downward-sloping curve along which an increase in the
unemployment rate is associated with a decrease in the inflation rate.
B. Aggregate Supply and the Short-Run Phillips Curve
The short-run Phillips curve is another way of looking at the upward-sloping aggregate supply
curve.
1. Unemployment and Real GDP
a. In a given period, with a fixed amount of capital and given state of technology, real GDP
depends on the quantity of labor employed.
b. At full employment, the quantity of real GDP is potential GDP and the unemployment rate
is the natural unemployment rate.
c. Okun’s law states that for each percentage point that the unemployment rate is above the
natural unemployment rate, there is a 2 percent gap between real GDP and potential GDP.
2. Inflation and the Price Level
The inflation rate is defined as the percentage change in the price level. So starting from any
given price level last period, the higher the inflation rate, the higher is the current period’s price
level.
a. Moving upward along the AS curve, the price level rises and real GDP increases.
b. Correspondingly, moving upward along the short-run Phillips curve, the inflation rate rises
and the unemployment rate decreases.
3. Aggregate Demand Fluctuations
Fluctuations in aggregate demand bring movements along the aggregate supply curve and
equivalent movements along the short-run Phillips curve.
C. Why Bother with the Phillips Curve?
1. It focuses directly on two policy targets, the inflation rate and the unemployment rate.
2. The aggregate supply curve shifts whenever the money wage rate or potential GDP changes, so
the aggregate supply curve is not a stable tradeoff.
17.2 Short-Run and Long-Run Phillips Curves
A. The Long-Run Phillips Curve
The long-run Phillips curve is the vertical line that shows the relationship between inflation and
unemployment when the economy is at full employment.
1. No Long-Run Tradeoff
Because the long-run Phillips curve is vertical, there is no long-run tradeoff between
unemployment and inflation.
B. Long-Run Adjustment in the AS-AD Model
When aggregate demand increases, the money wage rate rises to keep the real wage rate at its full-
employment level. As a result, aggregate supply decreases and the AS curve shifts leftward.
Further increases in aggregate demand elicit the same response.
C. Expected Inflation
The expected inflation rate is the inflation rate that people forecast and use to set the money
wage rate and other money prices.
1. When the expected inflation rate increases, the short-run Phillips curve shifts upward to
intersect the long-run Phillips curve at the new expected inflation rate.
2. When the expected inflation rate decreases, the short-run Phillips curve shifts downward to
intersect the long-run Phillips curve at the new expected inflation rate.
D. The Natural Rate Hypothesis
The natural rate hypothesis is the proposition that when the money growth rate changes, the
unemployment rate changes temporarily and eventually returns to the natural unemployment rate.
 E. Changes in the Natural Unemployment Rate
1. When the natural unemployment rate decreases, both the long-run Phillips curve and the short-
run Phillips curve shift leftward.
2. When the natural unemployment rate increases, both the long-run Phillips curve and the short-
run Phillips curve shift rightward.
F. Does the Natural Unemployment Rate Change?
1. An increasing number of economists question the idea that the natural unemployment rate is
constant because they think that changes in frictional and structural unemployment bring
changes in the natural unemployment rate.
2. It seems likely that the natural unemployment rate in 2002 is perhaps 5 or 6 percent, though
estimation of the natural unemployment rate remains tricky.
3. The “baby boom” generation entering the labor market during the late 1960s and early 1970s
probably increased the amount of job search and increased the natural unemployment rate.
During the 1990s, rapid technological change and an increase in the demand for labor made job
search faster and decreased the natural unemployment rate.
17.3 Expected Inflation
A. What Determines the Expected Inflation Rate?
1. The expected inflation rate is the inflation rate that people forecast and use to set the money
wage rate and other money prices.
2. People use data about past inflation and other relevant variables and the science of economics
to predict inflation.
3. A rational expectation is the inflation forecast resulting from use of all the relevant data and
economic science.
B. How Responsive Is the Tradeoff to a Change in Expected Inflation?
1. A change in the expected inflation rate shifts the short-run tradeoff gradually.
2. The reason for the gradual change is that the tradeoff depends on the rate of increase in the
money wage rate. Most money wage rates are set in advance, so they cannot immediately
incorporate changes in expected inflation.
C. What Can Policy Do to Lower Expected Inflation?
1. A Surprise Inflation Reduction
a. If the Fed raises interest rates and slows money growth when no one is expecting the Fed to
change its policy, then the Fed succeeds in slowing inflation but at the cost of recession.
b. Real GDP is below potential GDP and the unemployment rate is above the natural
unemployment rate.
2. A Credible Announced Inflation Reduction
a. If the Fed announces its intention to lower the inflation rate ahead of its action and the Fed is
credible, it succeeds in changing the expected inflation rate.
b. This announced inflation reduction lowers the inflation rate but with no accompanying loss
of output or increase in unemployment.
3. Inflation Reduction in Practice
Whether policy can lower inflation without a deep recession is a controversial question. As
recently as 1981 when the Fed slowed inflation, we paid a high price in the form of a recession
largely because the Fed's action was unexpected.