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Inflation and Unemployment
Read chapter 16 – pages 330-346.
I Relating Inflation and Unemployment
A) The Phillips curve is a curve that suggests
a negative relationship between inflation
and unemployment.
B) Historically, the Phillips curve seemed to
work all right during the 1960’s, but has
been less stable during more recent years.
C) The cycle of inflation and unemployment
1) The Phillips phase is a phase in which inflation
rises as unemployment falls.
2) The stagflation phase is a phase in which
inflation remains high while unemployment
increases.
3) The recovery phase is a phase in which inflation
and unemployment both decline.
4) The pattern of a sequence from Phillips phase, to
stagflation phase, to recovery phase is termed
the inflation-unemployment cycle.
II Explaining the Inflation-Unemployment
Cycle
A) The Phillips Phase: Increasing Aggregate
Demand. The Phillips phase occurs as
increases in aggregate demand (I.e. a shift
in the aggregate demand curve) move the
short run equilibrium along the short run
aggregate supply curve.
B) Changes in expectations and the
Stagflation Phase. This phase occurs
because workers and thus firms begin to
expect inflation and thus build it into labor
contracts and other prices. This results in a
shift of the short run aggregate supply curve
to the left, thus generating price increases
along with a drop in the short run level of
output and employment.
C) The Recovery Phase. This phase occurs
because of the response of policy makers to
the fall in equilibrium output which
occurred in the stagflation phase. In
particular, during the stagflation phase, we
saw that short run output fell below
potential. We would expect policy makers
to stimulate the economy thus shifting the
aggregate demand curve outward. The net
result is lower inflation and higher output
and employment in the short run.
III Inflation and Unemployment in the Long
Run.
A) The Inflation Rate in the Long Run
1) If the velocity of money is constant,
(i.e. % AV = 0) then the equation of
exchange implies,
% AP = % AM - % AYp.
2) Since potential output historically has
grown at 2.5%, we see that long run prices
are really determined by long run
monetary growth rates.
B) Unemployment in the Long Run
1) Recall there are three types of
unemployment: frictional, structural, and
cyclical.
2) In the long run only frictional and
structural are at issue since cyclical is by
definition a short run phenomena.
3) Basics behind frictional unemployment
a) The lowest wage that an unemployed
worker will accept is called the reservation
wage.
b) A simple search model.
i) An individual starts with a reservation
wage of W0 and reduces it as time
passes during their job search.
ii) The best offer received by an
individual gets better as the agent
receives more offers.
iii) Equilibrium duration offers at the
intersection of the reservation wage
curve and the best offer curve.
c) Things that can influence the equilibrium
duration of time.
i) Job market information is easier to
obtain. This shifts the best offer curve left,
thus lowering the job search duration and
frictional unemployment.
ii) Unemployment insurance increases the
reservation wage. This shifts the
reservation wage curve right, thus raising
the job search duration and frictional
unemployment.
4) Structural unemployment occurs because
some workers who were trained for
occupations no longer in demand thus do
not posses the skills for jobs currently in
demand.
a) Structural unemployment can be reduced
by job training programs or
b) job announcements for regions of the
country that may still demand those skills.
5) Cyclical Unemployment and Efficiency
Wages.
a) Some economists argue that there are
different reasons that explain the long run
level of unemployment. They argue that
wages are not determined as a results of
some market equilibrium and that the
market wage may stay above the market
equilibrium wage.
b) An efficiency wage is a wage greater than
the equilibrium wage.
c) The most common reasons for efficiency
wages is that it increases worker loyalty and
productivity.
d) If these exist then the ordinary process of
self correction will not eliminate a
recessionary gap.