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www.zomuedu.com Unit 6 The Phillips Curve ● Phillips Curve- A curve that shows the short-run tradeoff between inflation and unemployment ○ The curve shows the combinations of inflation and unemployment that arise in the short-run as shifts in the aggregate demand curve move the economy along the short run aggregate supply curve Aggregate Demand and Supply ● An increase in aggregate demand in the short run leads to an increase in the output of goods and services and a higher price level. Well, a larger output also indicates higher employment. However, because the price level increased in comparison to the year before, an increase in output also creates higher inflation. ○ A relationship between inflation and unemployment, in opposite directions, is shown. Higher inflation is equal to lower unemployment, and lower inflation is equal to higher unemployment. Monetary and Fiscal Policy ● Increases in money supply, increases in government spending, or tax cuts leads to the expansion of aggregate demand ○ Leads to a point on the Phillips curve with lower unemployment and higher inflation ● Decreases in money supply, cuts in government spending, or increases in taxes leads to the contraction of aggregate demand ○ Leads to a point on the Phillips curve with higher unemployment and lower inflation Shifts in the Phillips Curve: The Role of Expectations The Long Run Phillips Curve 2 ● For many years Friedman and Phelps denied the existence of a long run trade-off between inflation and unemployment. ○ These views have implications for the Phillips Curve ■ Monetary policymakers face a long run phillips curve that is vertical ● The unemployment rate tends to shift towards its normal rate ○ Natural Rate of Unemployment- 5% ○ The natural unemployment rate is where the economy tends to gravitate towards in the long run. However, the natural rate may not be socially desirable ○ Monetary policy cannot influence the natural rate of unemployment ○ To reduce the natural rate, policymakers should seek improvements in labor function ○ A POLICY THAT REDUCES THE NATURAL RATE WOULD SHIFT THE LONG RUN PHILLIPS CURVE TO THE LEFT Expectations and The Short-Run Phillips Curve ● Just as the aggregate supply curve slopes upward only in the short run, the tradeoff between unemployment and inflation only holds in the short run ● Expected Inflation- Measures how much people expect the overall price level to change ○ The expected price level affects the perceptions of relative prices (wages) ○ Expected inflation is one factor that dictates the placement of the short run aggregate supply curve ■ The fed can take expected inflation as already determined. When the money supply changes the AD curve will shift and the economy moves along the SRAS curve. Monetary changes lead to unexpected fluctuations in output, prices, ​unemployment​,​ inflation ● Unemployment= Natural Rate- a(Actual Inflation-Expected Inflation) ○ This equation implies that there is no stable short-run phillips curve ■ Each Short run phillips curve reflects a particular expected inflation rate ● Natural Rate Hypothesis- The Claim that Unemployment eventually returns to its natural status regardless of the rate of inflation 3 ● Supply Shock- An event that directly alters firms’ costs and prices, shifting the economy’s aggregate supply curve and thus the phillips curve ○ When an oil price increase raises the cost of producing gasoline, it reduces the quantity of gasoline supplied at any given price level. The reduction in supply, increase in price level, and decrease in output is called stagflation (Combination of rising prices and falling output). ○ Policymakers are confronted with a difficult decision of either fighting inflation or unemployment. ■ If they expand aggregate demand to fight unemployment, then inflation will raise further ● Policy makers have to live with a higher rate of inflation at a given unemployment rate ○ A policymaker is said to accommodate an adverse supply shock when they respond to it by increasing aggregate demand.