Chapter 1

An Introduction to Macroeconomics

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What is Macroeconomics?
• It is that part of economic theory which studies the economy in its totality or
as a whole.
• It studies not individual economic units like a household, a firm or an
industry but the whole economic system. Macroeconomics is the study of
aggregates and averages of the entire economy.
• Such aggregates are national income, total employment, aggregate savings
and investment, aggregate demand, aggregate supply general price level,
etc.
• Here, we study how these aggregates and averages of the economy as a
whole are determined and what causes fluctuations in them. Having
understood the determinants, the aim is how to ensure the maximum level of
income and employment in a country.
• In short, macroeconomics is the study of national aggregates or economy-
wide aggregates. In a way it is like study of economic forest as distinguished
from trees that comprise the forest. Main tools of its analysis are aggregate
demand and aggregate supply.

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Issues covered by Macroeconomists
• Long term macroeconomics
• Unemployment
• Inflation
• Business Cycles
• Fiscal & Monetary policies
• Money & Interest rates
• International Economics

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Time Frame in Macroeconomics

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1.1 Three Models
• Macroeconomics is organised around
three models.

• Each model is concerned with different

time frames:
– The long run
– The medium run
– The short run.

• Let’s consider each in more detail.

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Very Long Run Economic Growth
• The long run is a period of decades or more over
which potential output is expected to grow.

• The time period is usually measured in multiples

of decades (e.g. 20 years or more).

• Growth theory describes the long-run behaviour

of the economy.

• Short-run fluctuations in important variables like

employment, investment and output are ignored,
on the assumption that changes in these variables
average out over time.

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Very Long Run Economic Growth
• The long-run level of output is determined solely
by supply-side considerations.

• Output is determined by the productive capacity

of the economy.

• All factors of production (land, labour, capital and

technology) are assumed to be fully employed.

• The economy is operating at its ‘potential output’.

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Very Long Run Economic Growth
• Economic growth is a function of increases in
productive capacity.

• Major causes of economic growth are:

– Development of new technology
– Accumulation of physical and human capital
– Appropriate provision of infrastructure
– Higher rates of domestic saving.

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Very Long Run Economic Growth
• Economic growth determines the changes in
the standard of living.

• A country growing at an average of 4% per year

instead of 2% will have a 50% higher standard
of living over a generation of 20 years.

• This higher 4% average annual growth rate will

lead to a seven-fold increase in the standard of
living over 100 years!

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Fixed Productive Capacity
• In the long run the productive capacity of the
economy is assumed to be constant or fixed.

• The productive capacity of the economy

determines output.

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Fixed Productive Capacity
• This is represented by a vertical aggregate supply
schedule at real output level Y0 (potential output).

P AS
Price Level

Y0 Y

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Fixed Productive Capacity
• This level of output is associated with a certain
rate of growth in prices.

• What determines the change in the overall price

level (the inflation rate)?

• The aggregate supply (AS)–aggregate demand

(AD) model explains short- to medium-run
determination of inflation and real output.

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Fixed Productive Capacity

• The AD schedule represents, for each price level,

the level of output where both the goods and
money markets are in equilibrium.

• The intersection of the AS and AD schedules

determines the price (P0) and real output (Y0).

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Fixed Productive Capacity
• AD and AS in the long run.

What happens when

P AS AD shifts rightwards?
AD
Price increases
Price Level

P0 What happens when

AS shifts rightwards?
Price decreases

Y0 Y

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The Short Run
• The short run is a period of time short enough
that markets are unable to clear.

• In the short run actual output can deviate from

potential output.

• Short-run fluctuations in real output are important.

• AD is the major determinant of these variations.

• In the short run the price level is pegged, making

the short-run AS schedule horizontal.

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The Short Run
• AD and AS in the short run.

What happens when

P AD shifts rightwards?
Price unchanged
Price Level

P0 AS

AD

Y0 Y

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The Medium Run
• How do we describe the transition between
the short run and the long run?

• High AD pushes real output above Y0

(according to the long-run model).

• Over time, firms will increase prices and the

AS curve will move upwards.

• The medium run will give an upward-sloping

AS curve.

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The Medium Run
• The relative steepness of the AS curve is a
major controversy in macroeconomics.

P
Price Level

P0

AS AD

Y0 Y

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AS-AD Model
• Growth theory and the AS–AD framework can be
used to analyse many macroeconomic issues.

• These two models provide a basis for the further

analysis of:
– Growth and GDP
– The business cycle.

• Let’s consider each in turn.

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Gross Domestic Product
Two definitions:
1. Total expenditure on
domestically-produced
final goods and services
2. Total income earned by
domestically-located
factors of production
Why expenditure = income

In
In every
every transaction,
transaction,
the
the buyer’s
buyer’s expenditure
expenditure
becomes
becomes the the seller’s
seller’s income.
income.
Thus,
Thus, the
the sum
sum of of all
all
expenditure
expenditure equals
equals
the
the sum
sum of
of all
all income.
income.
Consumption (C)

def: the value of all goods • durable goods

and services bought by last a long time
households. Includes: ex: cars, home
appliances
• non-durable goods
last a short time
ex: food, clothing
• services
work done for
consumers
ex: dry cleaning,
air travel.
 U.S. Consumption, 2001

% of
$ billions
GDP
Consumption $7,064.5 69.2%
Durables 858.3 8.4
Nondurables 2,055.1 20.1
Services 4,151.1 40.7
Investment (I)
def1: spending on [the factor of production]
capital.
def2: spending on goods bought for future
use.
Includes:
 business fixed investment
spending on plant and equipment that firms will use to
produce other goods & services
 residential fixed investment
spending on housing units by consumers and landlords
 inventory investment
the change in the value of all firms’ inventories
 U.S. Investment, 2001

% of
$ billions
GDP
Investment $1,633.9 16.0%
Business fixed 1,246.0 12.2
Residential fixed 446.3 4.4
Inventory -58.4 -0.6
 Investment vs. Capital

• Capital is one of the factors of production.

At any given moment, the economy has a certain
overall stock of capital.
• Investment is spending on new capital.
Investment vs. Capital

Example (assumes no depreciation):

 1/1/2002:
economy has $500b worth of capital
 during 2002:
investment = $37b
 1/1/2003:
economy will have $537b worth of capital
Stocks vs. Flows
Flow Stock

More examples:
stock flow
a person’s wealth a person’s saving
# of people with # of new college
college degrees graduates
the govt. debt the govt. budget deficit
 Government spending (G)

• G includes all government spending on

goods and services.
• G excludes transfer payments
(e.g. unemployment insurance payments),
because they do not represent spending on
goods and services.
Government spending, 2001
% of
$ billions
GDP
Gov spending $1,839.5 18.0%
Federal 615.7 6.0
Non-defense 216.6 2.1
Defense 399.0 3.9
State & local 1,223.8 12.0
 Net exports (NX = EX - IM)

def: the value of total exports (EX)

minus the value of total imports (IM)
U.S. Net Exports, 1960-2000
50

0
$ billions

-50

-100

-150

-200

-250

-300

-350

-400
1960 1965 1970 1975 1980 1985 1990 1995 2000
 An important identity

Y = C + I + G + NX
where
Y = GDP = the value of total output
C + I + G + NX = aggregate expenditure
 A question for you:
Suppose a firm
• produces $10 million worth of final goods
• but only sells $9 million worth.

Does this violate the

expenditure = output identity?
 Why output = expenditure
• Unsold output goes into inventory,
and is counted as “inventory investment”…
…whether the inventory buildup was
intentional or not.
• In effect, we are assuming that
firms purchase their unsold output.
GDP:
An important and versatile concept
We have now seen that GDP measures
 total income
 total output
 total expenditure
 the sum of value-added at all stages
in the production of final goods
GNP vs. GDP
• Gross National Product (GNP):
total income earned by the nation’s factors of
production, regardless of where located
• Gross Domestic Product (GDP):
total income earned by domestically-located
factors of production, regardless of nationality.
(GNP – GDP) = (factor payments from
abroad)
– (factor payments to abroad)
Discussion Question:

What explains why GNP

differs from GDP for some of
the following countries?
Real vs. Nominal GDP
• GDP is the value of all final goods and services
produced.
• Nominal GDP measures these values using
current prices.
• Real GDP measure these values using the prices
of a base year.
Real GDP controls for inflation

Changes in nominal GDP can be due to:

 changes in prices
 changes in quantities of output
produced
Changes in real GDP can only be due to
changes in quantities,
because real GDP is constructed using
constant base-year prices.
 GDP Deflator
• The inflation rate is the percentage increase in the
overall level of prices.
• One measure of the price level is
the GDP Deflator, defined as

Nominal GDP
GDP deflator = 100 
Real GDP
Consumer Price Index (CPI)
• A measure of the overall level of prices
• Published by the Bureau of Labor
Statistics (BLS)
• Used to
– track changes in the
typical household’s cost of living
– adjust many contracts for inflation
(i.e. “COLAs”)
– allow comparisons of dollar figures from different years
How the BLS constructs the CPI
1. Survey consumers to determine
composition of the typical consumer’s
“basket” of goods.
2. Every month, collect data on prices of all
items in the basket; compute cost of basket
3. CPI in any month equals
Cost of basket in that month
100 
Cost of basket in base period
CPI vs. GDP deflator
prices of capital goods
• included in GDP deflator (if produced
domestically)
• excluded from CPI

prices of imported consumer goods

• included in CPI
• excluded from GDP deflator

the basket of goods

• CPI: fixed
• GDP deflator: changes every year
Growth and GDP

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Growth and GDP
• Table 1.1 compares the per capita real income
growth rates in various countries.

• Note the very large differences ranging from

0.3% for Ghana to 3.1% for Japan.

• Brazil (2.2%), China (3.1%) and France (2.0%)

are the next band.

• Note the lower but similar growth rates for

Australia (1.6%) and New Zealand (1.5%).

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Automatic stabilizers are ongoing government
policies that automatically adjust tax rates and
transfer payments in a manner that is intended to
stabilize incomes, consumption, and business
spending over the business cycle.

Automatic stabilizers are a type of fiscal policy,

which is favored by Keynesian economics as a
tool to combat economic slumps and recessions.

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Automatic stabilizers are primarily designed to
counter negative economic shocks or recessions,
though they can also be intended to “cool off” and
expanding economic or to combat inflation. By their
normal operation these policies take more money
out of the economy as taxes during periods of rapid
growth and higher incomes, and/or put more money
back into the economy in the form of government
spending or tax refunds when economic activity
slows or incomes fall. This has the intended purpose
of cushioning the economy from changes in the
business cycle.

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When an economy is in a recession, automatic
stabilizers may by design result in higher budget
deficits. This is an aspect of fiscal policy, a tool of
Keynesian economics use government spending and
taxes to support aggregate demand in the economy
through economic downturns. By taking less money
out of private businesses and households in taxes
and giving them more in the form of payments and
tax refunds, fiscal policy is supposed to encourage
them to increase, or at least not decrease, their
consumption and investment spending in order to
help prevent an economic set back from deepening.

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Money is an economic unit that functions as a
generally recognized medium of exchange for
transactional purposes in an economy. Money provides
the service of reducing transaction cost, namely the
double coincidence of wants. Money originates in the
form of a commodity, having a physical property to be
adopted by market participants as a medium of
exchange.

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• Money is a generally accepted, recognized, and
centralized medium of exchange in an economy that
is used to facilitate transactional trade for goods and
services.
• The use of money eliminates issues from the double
coincidence of wants that can occur in bartering.
• Economically, each government has its own money
system, defined and monitored by a central
authority.
• Cryptocurrencies represent a new form of money,
with international exchange opportunities.

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FUNCTIONS OF MONEY

1. Unit of Account
Due to its use as a medium of exchange for
both buying and selling and its use to assign
prices to all kinds of other goods and
services, money can be used to keep track
of the money gained or lost across multiple
transactions and to compare money values
of various combinations of different
quantities of different goods and services
mathematically.

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2. Store of Value
Because money's usefulness as a medium of
exchange in transactions is inherently future-
oriented, it provides a means to store value
obtained through current production or trade for
use in the future, in the form of other goods and
services. In particular trading their non-fungible,
non-durable, non-portable, non-recognizable, or
non-stable goods or services for money here and
now, people can store the value of those goods to
trade for goods at other times and places. This
facilitates saving for the future and engaging in
transactions over long distances possible.

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3. Standard of Deferred Payment
To the extent that money is accepted as a general
medium of exchange and serves as a useful store
of value, it can be used to transfer value for
exchange use at different times between people
through the tools of credit and debt. One person
can loan a quantity of money to another for a
period of time to use and repay another agreed-
upon quantity of money at a future date.

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TYPES OF MONEY

1. Market-Determined Money
Money originates as a feature of the spontaneous order of
markets through the practice of barter (or direct
exchange), where people trade one good or service
directly for another good or service. In order for a trade
to occur in barter, the parties to the exchange must want
the good or service that their counterparties have to offer.
This is known as the double coincidence of wants, and it
sharply limits the scope of transactions that can occur in
a barter economy. 

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However certain goods in a barter economy will be generally desired
by more people in trade for whatever they have to offer in barter.
These tend to be goods that have the best combination of the five
properties of money listed above. Over time these special kinds of
goods can come to be desired in trade partly for their wide acceptance,
as a means to overcome the problem posed by the double coincidence
of wants in future transactions with others. Eventually, people can
come to desire a good mostly or solely for its use-value in reducing
transaction costs in future exchanges.
Such a good can then be called money because it is generally
recognized by participants in the economy as a valuable good for its
use as a medium to indirectly exchange other goods and services
between multiple parties. The physical commodity will still have some
other use-value, but the primary use of any source of value has in the
market is for its use as money. Historically, precious metals like gold
and silver were adopted as these kinds of market-determined moneys.

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Commodity Money:
Money is a very old convenience since it is generally
accepted as a medium of exchange. In the earliest days of
human civilization, commodities were commonly used as
money. During the World War II, the British and German
prisoners of war camp used cigarettes amongst themselves
as the medium of exchange, rather by consensus and not by
the fiat of the government.
Anyway, cigarettes could not be thought of as ‘money’ in
the true sense because of its certain inherent characteris­tics.
At that time, it acted as a ‘crude’ form of money. But the
commodity money had no general acceptability since it
circulated as money in a particular locality.

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 Metallic Money:
Three metals—silver, copper and gold—were used for the
purpose of exchange. Of all the commodities, metals proved its
great advantages. More or less, all the attributes of good money
(e.g., stability of value, divisibility, cognoscibility, acceptability,
etc.) were to be found in money metals. But metallic money had
some inherent defects. Firstly, the ascertainment of the
quality of metals was a tiresome process.
Secondly, divisibility of metals for smaller transactions
was highly inconvenient, if not impossible. The invention
of coins removed some of these difficulties. The king of a
country had kept the right to issue coins with standard weight
and quality by stamping his name on them. This is how coins
came into existence.

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Paper Money:
After coinage, the next stage in the development of money was paper
money. Metallic money, made of precious metals, suffers from the
disadvantages of being stolen easily. t is both dangerous and inconvenient
to carry precious metals from one place to another. European merchants
and people kept their gold and silver with goldsmiths for safe custody.
Against these deposits of metals, goldsmiths issued a paper- receipt
showing a claim of the owners of metals. The receipts that the goldsmiths
issued were perhaps the first form of paper money. The depositors used
these metals to carry transactions, wherever the situation arose.
But it ultimately turned out to be cumbersome transactions. With the
passage of time, these goldsmiths were able to generate confidence
among depositors as well as general public. Consequently that bit of
paper became substitute for metallic money.
This document helped the process of transaction easily. Later on, the
issue of paper money was left into the hands of the commercial banks.
Nowadays, the central bank of a country has been given monopoly power
to issue paper notes.

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Credit Money:
Another type of money in the modern world is
credit money or bank money (cheques, drafts,
promissory notes, etc.). It is difficult to imagine a
modern economy without credit. Large
transactions over the entire country as well as
outside the country are credit transactions. With
the increase in economic activity, the need for an
ever-increasing supply of money is felt.

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Electronic Money or E-Money:
In this age of computer technology, we have
entered a new stage of evolution of the
payments system with the advent of electronic
money, e-money is a money that is stored
electronically, i.e., cheques are put in the e-
mail. Its important forms are credit cards,
debit cards and electronic cheques.

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Usually, there are two measures of the money
supply—narrow money supply, and broad money
supply. Because of the differences in the nature of
deposits of banks, we face two broad measures of
money supply.

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M1 = CP + demand deposits + other deposits
with the RBI.
M2 = M1 + post office savings bank deposits.
M3 = M2 + time deposits with banks.
M4 = M3 + total post office deposits (including
National Savings Certificate).

M0 = Currency + Reserves

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The Business Cycle and GDP
• The business cycle describes the variation of
economic activity around the path of trend growth.

• Inflation, growth and unemployment all

demonstrate cyclical patterns that contribute
to this variation.

• The output gap measures cyclical variations

in output from the trend growth path.

• It measures the difference between actual

and potential output.

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The Business Cycle and GDP
• Output gap = potential output – actual output.

• During a recession, actual output falls below

potential output. A negative gap is associated
with unemployment.

• During a boom, actual output rises above

potential output. A positive gap is associated
with over employment.

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The Business Cycle and Inflation
• The cost of the cycle above trend is inflation
and the cost below trend is unemployment.
• The costs of inflation are less obvious than
those of unemployment.
• Unemployment is associated with a loss in
potential output.
• Inflation upsets price relationships and
reduces the efficiency of the price system.

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Business Cycle Features

• Business cycles have common characteristics.

• Business cycles are associated with a pattern of

expansion (recovery) and contraction (recession).

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Business Cycle Features
• Economic variables can indicate something
of the nature of the business cycle.

• Procyclical variables rise with expansionary

business activity (e.g. output, employment,
interest rates and money supply).

• Countercyclical variables (like inventories and

bankruptcies) move in the opposite direction
to business activity.

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Business Cycle Features
• Some variables exhibit more variability
(volatility) than others.

• For example, inventories are volatile while

consumption is smooth, especially relative
to output.

• Business cycles do not occur as regular

fluctuations in the level of economic activity.

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Business Cycle Features
• The impulse-propagation model can be used
to explain what causes actual output to deviate
from the trend.

• The impulse-propagation model explains:

– How shocks (impulses) disturb the economy from
its long-run trend
– How this leads to effects that last (propagate) over time.

• Economists disagree over possible propagation

mechanisms.

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Business Cycle Features
• There are three broad types of shocks:
– Policy shocks, which affect fiscal expenditure and interest
rates (e.g. fiscal and monetary policies)
– Supply shocks, which affect production and price-setting
(e.g. technology advances)
– Private sector shocks, which affect aggregate demand
(e.g. changes in private investment).

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Business Cycle Features

• Various economic indicators can be used to

measure the course of the business cycle:
– Leading indicators, like firms’ profitability and building
approvals precede changes in GDP.
– Lagging indicators, like unemployment lag changes
in real GDP.
– Variables can be aggregated into a composite index
that will give a coincident index to measure turning
points in the business cycle.

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Business Cycle Features
• Two types of business cycle can be identified:
– The classical business cycle considers actual levels
so that a fall in GDP describes negative growth.
– Two consecutive quarters of negative growth in real
GDP is called a (classical) recession.
– The growth cycle considers fluctuations in growth rates
of the economy around the trend growth rate.

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1.3 Schools of Thought

• During the 1960s there were two main views:

– The monetarists believed the economy is best left
to itself.
– The Keynesian’s argued that government intervention
could improve economic performance.

• Two schools have developed since then:

– The New Classical school in the 1970s
– The New Keynesian school in the 1980–90s.

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New Classical School
• Three central assumptions of the New Classical
school are:
– Economic agents optimise
– Decisions are made rationally use all available
information (rational expectations)
– Markets are assumed to clear.

• These assumptions ensure there is no involuntary

unemployment.

• They also lead to a further assumption that

markets are continuously in equilibrium.

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New Keynesian School
• Extends the earlier Keynesian view that
markets will not always clear even if agents
are maximising.

• Reasons are varied and include:

– There is incomplete information.
– Institutions affect the workings of markets.
– Costs of changing wages and prices lead to price
rigidities.

• These reasons explain fluctuations in output

and employment.

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Economic Controversies
• The two main competing views of modern
macroeconomics are highlighted in real-world
political and media discussions.
• These differences are frequently exaggerated
in debate.
• There are significant areas of agreement.

• Debate and research continually evolve new

areas of consensus e.g. there is increasing
agreement on information problems with
wage-price setting.

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Chapter Organisation

1.1 Macroeconomics Encapsulated in

Three Models

1.2 To Reiterate . . .

1.3 Schools of Thought

1.4 Outline and Preview of the Text

1.5 Prerequisites and Recipes

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1.4 Text Outline and Preview
• The key overall concepts of this book are growth,
aggregate supply and demand.
– Chapters 3 and 4 consider long-run economic growth.
– Chapters 5–6 explore the AS curve and wage/price
impacts.
– Chapters 7–9 explore models of income and expenditure.
– Chapters 10–11 analyse international adjustment in
an integrating global economy.
– Chapters 12–16 examine individual sectors that make
up an economy.

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1.4 Text Outline and Preview

• The key overall concepts of this book are growth,

aggregate supply and demand.
– Chapters 17–19 consider big issues in economics
and related policy applications in an uncertain world.
– Chapter 20 introduces briefly some frontiers of
macroeconomic research.

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Inflationary Gap
Inflationary gap is the amount by which the actual
aggregate demand exceeds ‘aggregate supply at
level of full employment’.
BE is shown as inflationary gap. It is a measure of
the excess of aggregate demand over level of
output at full employment. Inflationary gap
causes a rise in price level which is called
inflation.

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1-89
Deflationary Gap:
Deflationary gap is the amount by which actual
aggregate demand falls short of aggregate
supply at level of full employment’.

It is a measure of amount of deficiency of

aggregate demand. Deflationary gap causes a
decline in output, income and employment
along with persistent fall in prices.

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Cyclical unemployment
Cyclical unemployment exists when
individuals lose their jobs as a result of a
downturn in aggregate demand (AD). If the
decline in aggregate demand is persistent,
and the unemployment long-term, it is called
either demand deficient, general, or Keynesian
 unemployment. 

Demand deficient unemployment

This is caused by a lack of aggregate demand,
with insufficient demand to generate full
employment.

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Structural unemployment
Structural unemployment occurs when certain
industries decline because of long term changes in
market conditions. For example, over the last 20
years UK motor vehicle production has declined while
car production in the Far East has increased, creating
structurally unemployed car workers. Globalisation is
an increasingly significant cause of structural
unemployment in many countries.

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Regional unemployment
When structural unemployment affects local areas
of an economy, it is called ‘regional’ unemployment.
For example, unemployed car workers in the
Midlands and Essex add to regional unemployment
in these areas. In the UK, the further we move away
from the affluent South East the greater the
unemployment rate. Geographical immobility makes
regional differences more extreme.

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Classical unemployment
Classical unemployment is caused when wages are
‘too’ high. This explanation of unemployment
dominated economic theory before the 1930s, when
workers themselves were blamed for not accepting
lower wages, or for asking for too high a wage.
Classical unemployment is also called real
wage unemployment.
Seasonal unemployment
Seasonal unemployment exists because certain
industries only produce or distribute their products
at certain times of the year. Industries where
seasonal unemployment is common include
farming, tourism, and construction.

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Frictional unemployment
Frictional unemployment, also called search unemployment,
occurs when workers lose their current job and are in the process
of finding another one. There may be little that can be done to
reduce this type of unemployment, other than provide better
information to reduce the search time. This suggests that zero
unemployment is impossible at any one time because some
workers will always be in the process of changing jobs.

Voluntary unemployment
Voluntary unemployment is defined as a situation when workers
choose not to work at the current equilibrium wage rate. For one
reason or another, workers may elect not to participate in the
labour market. There are several reasons for the existence of
voluntary unemployment including excessively generous welfare
benefits and high rates of income tax. Voluntary unemployment is
likely to occur when the equilibrium wage rate is below the wage
necessary to encourage individuals to supply their labour.

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The natural rate of unemployment
This is a term associated with new Classical and
monetarist economists. It is defined as the rate
of unemployment that still exists when the
labour market it in equilibrium, and includes
seasonal, frictional and voluntary
unemployment.

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An increase in the expected price level leads to
an increase in the nominal wage, in the same
proportion.

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An increase in unemployment leads to a decrease
in the nominal wage.
By the definition of z, an increase in z leads to an
increase in the nominal wage. For eg:
Unemployment Insurance

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Explaining the Phillips curve
The curve suggested that changes in the level of
unemployment have a direct and predictable effect on the
level of price inflation. The accepted explanation during the
1960’s was that a fiscal stimulus, and increase in AD, would
trigger the following sequence of responses:
1.An increase in the demand for labour as government
spending generates growth.
2.The pool of unemployed will fall.
3.Firms must compete for fewer workers by raising nominal
wages.
4.Workers have greater bargaining power to seek out
increases in nominal wages.
5.Wage costs will rise.
6.Faced with rising wage costs, firms pass on these cost
increases in higher prices.

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The breakdown of the Phillips curve
By the mid 1970s, it appeared that the Phillips
Curve trade off no longer existed – there no longer
seemed a stable pattern. The stable relationship
between unemployment and inflation appeared to
have broken down. It was possible to have a
number of inflation rates for any given
unemployment rate.
American economists Friedman and Phelps
offered one explanation – namely that there is not
one Phillips curve, but a series of short run Phillips
Curves and a long run Phillips Curve, which exists at
the natural rate of unemployment (NRU). Indeed, in
the long-run, there is no trade-off between
unemployment and inflation.

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• Money illusion posits that people
have a tendency to view their
wealth and income in
nominal dollar terms, rather than
recognize its real value, adjusted
for inflation.
• Economists cite factors such as a
lack of financial education, and
the price stickiness seen in many
goods and services as triggers of
money illusion.
• Employers are sometimes said to
take advantage of this, modestly
lifting wages in nominal terms
without actually paying more in
real terms.
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