Transcript Phillips Curve

Introduction to Macroeconomics
Chapter 22
Short run tradeoff between inflation
and unemployment
Goals of Gov’t Policies
Recall that monetary and fiscal policy should be
used to stabilize the economy:
• Decrease unemployment (promote economic growth)
• Decrease inflation
But there is a short run tradeoff:
• To decrease inflation leads to increase unemployment
• To decrease unemployment leads to increase inflation
Phillips Curve
Phillips Curve illustrates the tradeoff between
inflation and unemployment
• In the LR: due to monetary neutrality and classical
dichotomy  NO TRADEOFF
• In the SR: the tradeoff is based on the short run
equilibrium in the AD-AS model
Unemployment in the long run is determined by:
- Structural Barriers
- Frictional Unemployment
Prices do not affect the natural rate of unemployment
Short Run Phillips Curve
U = NRU – a(actual inf. – expected inf.)
• When expectations match actual inflation: U = NRU
• When expectations > actual = U < NRU
• When expectations < actual = U > NRU
Why Inflation Expectations Matter:
http://realestate.aol.com/blog/videos/greenliving/519043174/
Application 1
Consider the impact of expansionary monetary
policy on the AD-AS model.
- Illustrate the AD-AS model and impact of the change in
monetary policy
- What happens to the price level? How does this impact
inflation?
- What happens to output? How does this affect
unemployment?
- Illustrate this effect on the Short Run Phillips Curve
Application 2
Now consider the impact of an oil shock on the economy.
What if the price of oil increased suddenly from $50 per
barrel to $100 per barrel?
- Illustrate the AD-AS model and impact of the change.
- What happens to the price level? How does this impact
inflation?
- What happens to output? How does this affect
unemployment?
- Illustrate this effect on the Short Run Phillips Curve
- Can the government counter this effect? If so, how? What
impact would the government intervention have on
inflation and unemployment?
Short Run Tradeoffs
To stabilize the economy in times of shocks or
recessions, the government faces a tradeoff
• Act to lower inflation (decrease AD) at the cost of
higher unemployment
• Act to lower unemployment (increase AD) at the cost
of higher inflation
• Can’t do both!
Key Takeaways
• The Phillips Curve provides guidance for
policymakers in the short run in deciding to
reach inflation or unemployment targets
• Links what happens in the aggregate economy
(AD-AS model) to inflation and unemployment
outcomes in the economy