EXEE 2104 Macroeconomics llB
Tutorial 5: Output, Inflation, and Unemployment: Alternative Views
Group 2E: FATIMAH BINTI ALI EEE 070049 LIM WEI ZING EEE 070084
Milton Friedman believes that there will be
only a temporary trade-off between inflation and unemployment. Explain why.
The Short Run Phillips Curve
The Phillips Curve shows a relationship between unemployment rate and inflation rate. • The short run Phillips Curve has a negative slope. • The negative slope show that the unemployment rate and the inflation rate are inversely related. ( there is a trade off between the two)
Inflation Rate 6
The Long Run Phillips Curve
Inflation and unemployme nt are unrelated in the long run. • The LR Phillips Curve is vertical at the natural rate of unemployme nt.
Inflation Rate High Inflatio n Low Inflatio n
Natural Rate of Unemploym ent
Unemployme nt Rate
• Milton Friedman said there is always a
temporary trade-off between inflation and unemployment; there is no permanent tradeoff. • In other words, if policymakers were to try to keep unemployment low through a policy of generating higher inflation, they would achieve only temporary success. • According to Friedman, unemployment would eventually rise again, even as inflation remained high. The economy would suffer "stagflation."
• Friedman applied the idea of rational
behaviour. He argued that after a sustained period of inflation, people would build expectations of future inflation into their decisions, nullifying any positive effects of inflation on employment. • For example, one reason inflation may lead to higher employment is that hiring more workers becomes profitable when prices rise faster than wages. But once workers understand that the purchasing power of their wages will be eroded by inflation, they will demand higher wage settlements in advance, so that wages keep up with prices. • As a result, after inflation has gone on for a while, it will no longer deliver the original boost to employment. In fact, there will be a
Short-Run and Long-Run Phillips Curves
As labor suppliers come to anticipate the higher inflation rate, the short-run Phillips curve shifts from PC(Pe=0) to PC (Pe=2%). The unemploymen t rate returns to the natural rate of 6%: the inflation rate remains higher at 2%
PC(Pe=0) PC(Pe=2%) PC(Pe=P)
6 4 2 B C A 2 4 6
Suppose that there is a permanent increase
in the level of government spending financed by a larger budget deficit. What would Keynesians predict would happen to inflation and unemployment as a result? What would Monetarists predict would happen to inflation and unemployment as a result?
When the expenditures of a government are
greater than its tax revenues, it creates a deficit in the government budget; such a deficit is known as deficit spending. This therefore causes the government to borrow capital from the 'world market', increasing further debt, debt service (interest) and interest rates. When the economy has high unemployment, an increase in government purchases creates a market for business output, creating income and encouraging increases in consumer spending, which creates further increases in the demand for business output. This raises the real gross domestic product (GDP) and the employment of labour, and lowers the unemployment rate.
Effect of an increase in Government Spending
G AD curve shift up to the right ( from AD0 to AD1 ) P ( from P0 to P1 ) and Y (from Y0 to Y1 )
The Keynesian View
r AS P1 P0 AD1(G1) Y
AD0(G0 ) Y1
• In the Short
Run, there is a trade off between inflation and unemployment rate. •High rate growth of output correspond to low unemployment and high rates of inflation. • As suppliers of labor anticipate that prices are rising, PC will shift to the right. • If the money growth is continued at 5%, the economy will return to the natural 6% rate of
THE MONETARIST APPROACH
Monetarists argue: a) attempt to reduce unemployment by increasing the government deficit do not succeed if the government finances the additional deficit by borrowing other than from banks. The additional supply of bonds increases interest rates, and this reduces private investment, with reduction in employment and output, creating inflationary pressures. b) national income increases if the additional government deficit is financed by increases in cash creation or borrowing from banks. This monetary policy increases
The monetarist conclusion is that Keynesian
fiscal policies CAN DO NOTHING TO AFFECT THE LONG-TERM LEVEL OF UNEMPLOYMENT and that government policies affect the inflation rate only if the supply of money is changed.
Question 3 What is meant by the natural rate of unemployment? According to the Monetarist view, does an expansionary monetary policy lower the natural rate of unemployment temporarily or permanently?
What is meant by the natural rate of unemployment?
The natural rate of unemployment is
defined by the Friedman as the rate “which has the property that that it is consistent with equilibrium in corresponding natural rate of employment, will be such that labor demand equals labor supply at an equilibrium real wage.
a. Natural Rate of Employment
The labor demand Nd
MPN N* Y Y *
b. Natural Rate of Output
schedule in figure a of the figure is the familiar marginal product of labor schedule (MPN). At N*, the natural rate of employment, Nd = Ns Figure b by using production function , we can find the level of output that will result from an employment
According to the Monetarist views, does an expansionary monetary policy lower the natural rate of unemployment temporarily or permanently?
Expansionary monetary policies, for example,
move output above the natural rate and move the unemployment rate below the natural rate for a time. The increased demand resulting from such, an expansionary policy would also cause prices to rise. In the short-run, the price adjustment would not be complete, as in the classical theory where increases in demand cause prices to rise but do not affect output. Monetarists believe that expansionary monetary policy can only temporarily move the unemployment rate below the natural rate
Temporarily, expansionary monetary policy lower the unemployment rate at B (SR). Permanently, the unemployment rate remain unchanged at C (LR).
Question 4 Why is the Philips curve implied by the Keynesian model downward sloping? Does this apply to both the long- run and the short-run effects of the monetary policy? Is there any difference between monetarists and Keynesian views on the Philips curve?
Why is the Philips curve implied by the Keynesian model downward sloping?
P(Inflatio n Rate)
The Philips curve show a
relation between the unemployment rate (U) and inflation (p). In the short-run Philips curve has negative slope. It means that the downward sloping is that the unemployment rate and the inflation rate are inversely related. Have trade off unemployment in shortrun. When u p that why the Philips curve downward sloping. But it only imply in shortrun
Phillips curve viewed by Keynesian is downward sloping because: - There is a –(ve) relationship between inflation and unemployment. - High inflation rate, low unemployment rate and vice versa. But it only imply in short run.
In short-run, increase in inflation will decrease unemployment. While decrease in inflation will increase unemployment. This is because the expected price level (Pe) is depending on past price.
╥0 ╥1 U
Does this apply to both the long- run and the short-run effects of the monetary policy?
No , however the
Natural rate of Unemployment unemployment Rate
downward sloping curves does not occur in the long run. In the long-run the Phillips curve is vertical at the natural rate of unemployment. In the long run increase in inflation, unemployment remain unchanged Friedman and Phelps says that inflation and unemployment are unrelated in the LR.
Is there any difference between monetarists and Keynesian views on the Philips curve?
According to keynesian in the SR there is trade
off between inflation and unemployment, where decreasing in unemployment will increase inflation and vice versa. When the PCSR downward sloping the same things will happened in the monetarist theory. That means there is no diffirent PC viewed by Monetarist and Keynesians.
Contrast monetarist and classical views on the short-run effects of an increase in the quantity of money.
• In classical
model, an increase in money supply does not affect the output because the AS curve is vertical.
• Ms increase,
B A AD1 AD0 Y0 Y
AD shifts to the right, P increase..
• In monetarist
model, an increase in money supply will affect the output because the AS curve is upward sloping.
• Ms increase,
P1 P0 AD(M1) AD(M0) Y0 Y1 Y
AD shift to right. P increase and Y increase.