Issues in

macroeconomic
theory and policy

Denissee Marie Malabayabas

Dianne Pascua
Jon Gab Paredes
 PHILLIPS CURVE
– WILLIAM PHILLIPS

- Shows the relationship between

unemployment and inflation in an economy.
 ◀ Higher rates of inflation, the rate of unemployment is
. lower, while during period of relatively stable of . .
. falling prices, unemployment is substantial.

◀ Reasons:
◂ During boom
◂ Demand for labor increases
◂ Due to greater bargaining power of the trade union
◂ Wage increases
Inflation – Low
unemployment

Low inflation – High

unemployment
 The Phillips Curve and
Aggregate Supply and Aggregate
Demand
 THE SHORT-RUN PHILLIPS
CURVE VERSUS THE LONG-RUN
PHILLIPS CURVE
◂ Natural rate hypothesis or non-accelerating inflation rate of
unemployment (NAIRU)
- theory that describes how the short-run Phillips curve shifts in the long
. run as expectations change

◂ Natural rate of unemployment

- the hypothetical unemployment rate consistent with aggregate . ...
.. production being at the long-run level
◂ The long-run Phillips curve is a vertical line at the natural rate
of unemployment, but the short-run Phillips curve is roughly L-
shaped.
◂ The inverse relationship shown by the short-run Phillips
curve only exists in the short-run, there is no trade-off
between inflation and unemployment in the long run.

◂ Decreases in unemployment can lead to increases in

inflation, but only in the short run. In the long run, inflation
and unemployment are unrelated.

◂ Adaptive expectations theory: A hypothesized process by

which people form their expectations about what will happen in
the future based on what has happened in the past.
◂ Expansionary efforts to decrease unemployment below the
natural rate of unemployment will result in inflation. This
leads to shifts in the short-run Phillips curve.

◂ In the short run, the increase in aggregate demand

increases output and decreases unemployment.

◂ Natural level of real output or unemployment from the

natural rate of unemployment is ineffective in the long run.
 SUPPLY SHOCK
- An event that suddenly changes the price of a commodity or
service. It may be caused by a sudden increase or decrease in
the supply of a particular good.
◂ Stagflation is a combination of the words “stagnant” and
“inflation.

◂ The stagflation of the 1970’s was caused by a series of

aggregate supply shocks.

◂ In this case, huge increases in oil prices by the Organization

of Petroleum Exporting Countries (OPEC) created a severe
negative supply shock.
◂ As aggregate supply decreased, real GDP output decreased,
which increased unemployment, and price level increased; in
other words, the shift in aggregate supply created cost-push
inflation.
Rational Expectations and
Real Business Cycle
• Belief that workers and consumers incorporate
the likely consequences of government policy
changes into their expectations by quickly
adjusting wages and prices.

Rational Expectations
Theory
Anticipation of an Expansionary Monetary Policy
Unanticipated of an Expansionary Monetary Policy
Real Business Cycle
Theory

The business cycle is the fluctuation in economic

activity that an economy experiences over a period
of time. A business cycle is basically defined in
terms of periods of expansion or recession.
 CONTROVERSIES IN
MACROECONOMICS
• Are Fiscal and Monetary Policies Effective?

The activists believed that in the short run, monetary and fiscal policy can
stimulate the economy that is in a recessionary gap or inflationary gap.

Other economists, rational expectation theorists, believed that government

policies is not effective to alter aggregate demand because households and
firms form expectation to economic policy causing price and wages to
adjust quickly, leaving the output the same at a higher price level.

The real business cycle theorists believe that fiscal and monetary policy is
are not needed except in keeping the inflation check because prices and
wages are flexible that the market adjusts quickly and restores full
employment at new level of output.
NEGATIVE SUPPLY SHOCK
• A negative supply shock cause
production costs to rise and lowers
the amount producers are willing to
supply at any given aggregate price
level. The result is a lower aggregate
output and a higher price level.
POLICY RESPONSE TO SUPPLY SHOCK
WHAT SHOULD THE
CENTRAL BANK DO ?
Monetary policy should take the lead in stabilization policy
that the central bank should be independent and should adopt
rules, such as constant growth rate and money supply.
INFLATION TARGETING
Targeting the inflation rate would require the central bank to
attempt to stay in a certain band of inflation for a specified period
of time.

TARGETING INFLATION AT
ZERO
An inflation rate of zero is almost impossible
and costs are too high.
TAYLOR RULE
Taylor rule is a reduced form approximation of the responsiveness of the
nominal interest rate, as set by the central bank, to changes
in inflation, output, or other economic conditions. In particular, the rule
describes how, for each one-percent increase in inflation, the central bank
tends to raise the nominal interest rate by more than one percentage point.
ASSET PRICE INFLATION
Asset price inflation is an economic phenomenon denoting a rise
in price of assets, as opposed to ordinary goods and services.
INDEXING AND REDUCING
COSTS OF INFLATION
Indexing is a technique to adjust income payments by means of
a price index in order to maintain the purchasing power of the
public after inflation.