Transcript Phillips Curve

The Phillips Curve
Unemployment
vs.
Inflation
Managing the short run trade-off
Full Employment & Inflation
• Full Employment % depends on features of a labor market:
• Including: minimum-wage laws, the market power of unions, the
effectiveness of job search (think internet) , & other labor laws etc….
• In USA = 4.5%
• Inflation rate depends on growth in the quantity of money
• Supply of money is controlled by the Federal Reserve
Short Run trade off: Fiscal Policy
• If fiscal policy ↑ AD => unemployment ↓, but inflation ↑
• If fiscal policy ↓ AD, inflation ↓, but ↑ unemployment
AD2
Short Run Phillips Curve (SRPC)
% Inflation
Rate
You can only lower unemployment
by creating ↑ inflation
B
6
A
2
0
SRPC
4
7
% Unemployment
Rate
SRAS & SRPC
1) Movements along SRAS => movements along SRPC
2) Shifts in SRAS => SRPC shifts in opposite direction
AS/AD Model
Short Run Phillips Curve
Price
Level
6
B
106
102
Inflation
Rate
(percent
per year)
SRAS
B
A
AD2
A
2
AD1
0
7,500 8,000
(unemployment (unemployment
is 7%)
is 4%)
SRPC
Real GDP
or Output
0
4
(output is
8,000)
Unemployment
7
(output is Rate (percent)
7,500)
The Long-Run Phillips Curve
• In the 1960s, Friedman & Phelps concluded that inflation &
unemployment are unrelated in long run
In the long run,
Inflation is only related to the Quantity
Of Money (Money Supply)
Therefore, the Long-Run Phillips curve
is vertical at full employment level
The Long-Run Phillips Curve
Inflation
Rate
1. When the
Fed increases
Money supply
The rate of
inflation rises
High
inflation
Low
inflation
0
LRPC
B
A
Natural rate of
unemployment
2. . . . but unemployment
remains at its natural rate
in the long run.
Unemployment
Rate
LRAS & Long Run Phillips Curve
AS/AD Model
Price
Level
P2
2. . . . raises
the price
P
level . . .
Long Run Phillips Curve
Inflation
Rate
LRAS
B
3. . . . and
increases the
inflation rate . . .
1. An decrease in
Taxes increases
Aggregate demand
..
LRPC
B
A
A
AD2
AD1
0
Natural rate
of output
Quantity
of Output
0
4. . . . but leaves output and unemployment
at their natural rates.
Natural rate of
unemployment
Unemployment
Rate
Long Run Conclusion
• In long run, expected inflation adjusts to changes in actual inflation
• Fiscal Policy is not effective in lowering unemployment
– only in increasing inflation
• Fed can only create unexpected inflation in short run
– However, once people anticipate inflation, they adjust.
– Only way to get unemployment below the natural rate is for actual inflation to
be above anticipated inflation (inflationary gap)