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Chapter 5 Phillips curve: shows the short-run trade-off between inflation and unemployment 1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in the U.K. 1960: Paul Samuelson & Robert Solow found a negative correlation between U.S. inflation & unemployment, named it “the Phillips Curve.” “The Phillips 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” (803). PL=100 in 2020 Two outcomes are possible in 2021 If AD is high… PL rises by a lot (output increases substantially) (B) If AD is low… PL rises by a little (output increases slightly) inflatio P (A) n SRAS 105 103 B 5% A AD2 B A 3% PC AD1 Y1 Y2 Y 4% 6% u-rate Both graphs are connected As “A” moves to “B” the output increases Higher output= higher demand for workers Higher demand for workers= lower unemployment As “A” moves to “B” the PL increases Increasing the PL increases the rate of Inflation Fiscal and monetary policies affect the AD; therefore, the PC offers policymakers a menu of choices: low unemployment with high inflation low inflation with high unemployment anything in between Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or “natural” rate, regardless of the inflation rate Based on the classical dichotomy and the vertical LRAS curve P Inflatio n LRAS LRPC high inflation P2 P1 AD2 AD1 Natural rate of output low inflatio n Y Natural rate of unemployment u-rate Since the LRAS curve is vertical, and output stays constant, any increase in AD just increases Inflation. Expected Inflation: Measure of how much people expect the overall PL to change Unemployment Rate (UR) Natural Rate of Unemployment (NRU) Actual Inflation (AI) Expected Inflation (EI) UR= NRU+ a(AI – EI) a= in a parameter of how much unemployment responds to unexpected inflation Short run Fed can reduce u-rate below the natural u-rate by making inflation greater than expected. Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low. Natural-Rate Hypothesis: Claims that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation Supply shock: an event that directly alters firms’ costs and prices, shifting the AS and PC curves Example: large increase in oil prices P Inflatio n SRAS2 P2 SRAS1 B A A P1 Y2 Y1 B A D Y PC2 PC1 U-Rate SRAS Curve shifts left: Output decreases Price level increases Unemployment rises Sacrifice Ratio: The number or % points of annual output lost in the process of reducing inflation by 1% point Rational Expectations: The theory that people optimally use all the information they have including information about gov.t policies, when forecasting the future Typical estimate of the sacrifice ratio: 5 To reduce inflation rate 1%, must sacrifice 5% of a year’s output. Can spread cost over time, e.g. To reduce inflation by 6%, can either sacrifice 30% of GDP for one year sacrifice 10% of GDP for three years Ex. Fed claims that they’re going to reduce inflation Expected Inflation decreases (SRPC shifts downward) Result: Disinflations can cause less unemployment that the traditional sacrifice ratio predicts.