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The Short-Run Trade-Off between Inflation and Unemployment Copyright © 2006 Thomson Learning 35 Figure 1 The Phillips Curve Inflation Rate (percent per year) B 6 A 2 Phillips curve 0 4 7 Unemployment Rate (percent) Copyright © 2004 South-Western Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level 102 Inflation Rate (percent per year) Short-run aggregate supply 6 B 106 B A High aggregate demand Low aggregate demand 0 (b) The Phillips Curve 7,500 8,000 (unemployment (unemployment is 7%) is 4%) Quantity of Output A 2 Phillips curve 0 4 (output is 8,000) Unemployment 7 (output is Rate (percent) 7,500) Copyright © 2004 South-Western Figure 3 The Long-Run Phillips Curve Inflation Rate 1. When the High central bank inflation increases the growth rate of the money supply, the rate of inflation increases . . . Low inflation 0 Long-run Phillips curve B A Natural rate of unemployment 2. . . . but unemployment remains at its natural rate in the long run. Unemployment Rate Copyright © 2004 South-Western Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level P2 2. . . . raises the price P level . . . Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand . . . (b) The Phillips Curve Inflation Rate Long-run Phillips curve 3. . . . and increases the inflation rate . . . B A A AD2 Aggregate demand, AD 0 Natural rate of output Quantity of Output 0 Natural rate of unemployment Unemployment Rate 4. . . . but leaves output and unemployment at their natural rates. Copyright © 2004 South-Western Figure 5 How Expected Inflation Shifts the ShortRun Phillips Curve Inflation Rate 2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Long-run Phillips curve C B Short-run Phillips curve with high expected inflation A 1. Expansionary policy moves the economy up along the short-run Phillips curve . . . 0 Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment Rate Copyright © 2004 South-Western Figure 6 The Breakdown of the Phillips Curve Copyright © 2004 South-Western Figure 7 An Adverse Shock to Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level AS2 P2 3. . . . and raises the price level . . . B A P Aggregate supply, AS (b) The Phillips Curve Inflation Rate 1. An adverse shift in aggregate supply . . . 4. . . . giving policymakers a less favourable trade-off between unemployment and inflation. B A PC2 Aggregate demand 0 Y2 Y 2. . . . lowers output . . . Quantity of Output Phillips curve, P C 0 Unemployment Rate Copyright © 2004 South-Western Figure 8 The Supply Shocks of the 1970s Copyright © 2004 South-Western Figure 9 Disinflationary Monetary Policy in the Short Run and the Long Run Inflation Rate Long-run Phillips curve 1. Contractionary policy moves the economy down along the short-run Phillips curve . . . A Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation 0 Natural rate of unemployment Unemployment 2. . . . but in the long run, expected Rate inflation falls, and the short-run Phillips curve shifts to the left. Copyright © 2004 South-Western Figure 10 The Thatcher Disinflation Copyright © 2004 South-Western