Transcript Document

Lesson 16-1
Relating Inflation and Unemployment
The Phillips Curve
A Phillips curve suggests a negative relationship
between inflation and unemployment.
The Phillips curve trade-off between inflation and
unemployment is implied by
Keynesian analysis.
The experience of the 1960s suggested that the
Phillips curve did exist in the United States.
The Phillips Curve Goes Awry
In the 1970s, both the unemployment rate and the
inflation rate rose and fell simultaneously.
The 1960s appear to be atypical.
Empirical evidence shows no sign of a meaningful
Phillips Curve relationship over the period 1961 to
1998.
The Cycle of Inflation and Unemployment
The Phillips phase is a period in which inflation rises as
unemployment falls.
The stagflation phase is a period marked by high inflation and
increasing unemployment.
The recovery phase is a period in which inflation and unemployment
both decline.
The inflation-unemployment cycle is the pattern of a Phillips phase,
stagflation phase, and recovery phase observed in the relationship
between inflation and unemployment.
The data show that the economy went through three inflationunemployment cycles during the 1970s.
Explaining the Inflation-Unemployment Cycle
The Phillips Phase: Increasing Aggregate Demand
Start from a recessionary gap to which authorities respond
with expansionary monetary or fiscal policy.
Aggregate demand increases, pushing real GDP and the
price level up along the short-run aggregate supply curve
and lowering unemployment.
Impact lags in macroeconomic policy lead to continuing
increases in aggregate demand in subsequent periods and
the repetition of the process above.
The rising employment and real GDP occur
because sticky prices and wages that in the face of
nominal price increases are reduced in value give
an incentive to expand employment.
Eventually workers and firms will begin adjusting
nominal wages and other sticky
prices to reflect the new higher level of prices that
emerges during the Phillips phase.
Changes in Expectations and the Stagflation Phase
Workers and firms adjust their expectations to a higher
price level, resulting in new agreements on wages with
higher nominal wages.
Higher wages cause a leftward shift of the short-run
aggregate supply curve.
This decrease in the short-run aggregate supply curve
results in increases in both unemployment and
inflation.
The essential feature of the stagflation phase is a
change in expectations.
The Recovery Phase
Government attempts to stop the recession created in
the stagflation phase.
Expansionary macroeconomic policy shifts the
aggregate demand to create a new equilibrium of
aggregate demand and SRAS.
This results in lower unemployment and higher prices,
but the price rise is less than before, so the inflation
rate is lower.
There are other determinants of inflation and
unemployment.
Changes in production costs shift the short-run
aggregate supply curve.
Depending on when such shifts occur, they can
reinforce or reduce the swings in inflation and
unemployment.
Lags also play a crucial role in the cycle.
Because of the lags in expansionary policy
policymakers may respond a second time too
quickly and create overstimulation in subsequent
periods.