Embed Size (px)
Citation preview
Inflation and Unemployment: The
Phillips CurveCan Governments Lower Unemployment at No Cost?
The Short-Run Phillips CurveInflation rate
Unemployment rate
0
When the unemployment rate is low, inflation is high
Short-run Phillips curve,SRPC
When the unemployment rate is high, inflation is low
The Short-Run Phillips Curve and Supply Shocks
Inflation rate
Unemployment rate
0
A negative supply shock shifts SRPC up
A positive supply shock shifts SRPC down
SRPC0
SRPC1
SRPC2
Expected Inflation and the Short-run Phillips Curve
Inflation rate
Unemployment rate
0
SRPC shifts up by the amount of the increase in expected inflation
SRPC0
SRPC3
4%
-2%
2%
-6%
-4%
6%
8%
10%
742 98653 1 10
3%
1%
5%
7%
9%
-1%
-5%
-3%
The NAIRU and the Long-Run Phillips Curve
Inflation rate
Unemployment rate
0
SRPC0
4%
-2%
2%
-6%
-4%
6%
8%
10%
742 98653 1 10
3%
1%
5%
7%
9%
-1%
-5%
-3%
E0
Suppose the government attempts to push unemployment down (say to 5%), at the cost of higher inflation. What will happen?
E2
Positive Demand Shocks: Short-Run and Long-Run Effects 1. A positive demand shock
occurs (in this case, government spends more or cuts taxes)…
AD2AD1
Aggregate Price Level
Real GDPY1 Y2
P1
P2
E1
LRAS
Inflationary gap
Potentialoutput
2. …which increases the aggregate price level and aggregate output.
SRAS1
• This leads to lower unemployment in the short run…
Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?
A
The NAIRU and the Long-Run Phillips Curve
Inflation rate
Unemployment rate
0
SRPC0
4%
-2%
2%
-6%
-4%
6%
8%
10%
742 98653 1 10
3%
1%
5%
7%
9%
-1%
-5%
-3%
E0
Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?
What happens if the government continues on this course (trying to force down unemployment with higher inflation)?
What effect did the government’s manipulation of AD have on the SRPC?
E2
Positive Demand Shocks: Short-Run and Long-Run Effects 1. A positive demand shock
occurs (in this case, government spends more or cuts taxes)…
AD2AD1
Aggregate Price Level
Real GDPY1 Y2
P1
P2
E1
LRAS
Inflationary gap
Potentialoutput
2. …which increases the aggregate price level and aggregate output.
SRAS2 SRAS1
3. …until an eventual rise in nominal wages in the long run causes a negative supply shock.
E3P3
• This leads to lower unemployment in the short run…
…and moves the economy back to potential output.
• This decreases short-run aggregate supply
Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?
E2A
The NAIRU and the Long-Run Phillips Curve
Inflation rate
Unemployment rate
0
SRPC0
4%
-2%
2%
-6%
-4%
6%
8%
10%
742 98653 1 10
3%
1%
5%
7%
9%
-1%
-5%
-3%SRPC2
E0
Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?
What happens if the government continues on this course (trying to force down unemployment with higher inflation)?
What effect did the government’s manipulation of AD have on the SRPC? Consumers build-in their
expectations for inflation, and unemployment returns to its former levels.
So what if the government tries again?
E2
Positive Demand Shocks: Short-Run and Long-Run Effects 1. In Round 2, another
positive demand shock occurs (through more government spending) but now from the already higher price level...
AD2AD1
Aggregate Price Level
Real GDPY1 Y2
P1
P2
E1
LRAS
Inflationary gap
Potentialoutput
2. …which increases the aggregate price level and aggregate output.
SRAS2 SRAS1
3. …until an eventual rise in nominal wages in the long run causes a negative supply shock.
E3P3
• This leads to lower unemployment in the short run…
…and moves the economy back to potential output.
• This decreases short-run aggregate supply
E4
E2
C
B
A
The NAIRU and the Long-Run Phillips Curve
Inflation rate
Unemployment rate
0
Nonaccelerating inflation rate of unemployment, NAIRU
SRPC0
SRPC4
4%
-2%
2%
-6%
-4%
6%
8%
10%
742 98653 1 10
3%
1%
5%
7%
9%
-1%
-5%
-3%SRPC2
Long-run Phillips curve, LRPC
E0
Suppose the government attempts to push unemployment down, at the cost of higher inflation. What will happen?
What happens if the government continues on this course (trying to force down unemployment with higher inflation)?
What effect did the government’s manipulation of AD have on the SRPC? Consumers build-in their
expectations for inflation, and unemployment returns to its former levels.
So what if the government tries again?
Phillips Curve Questions
• Draw a graph AND EXPLAIN what would happen to SRPC in the following scenarios:
1. Government increases spending2. The price of crude oil and most energy sources increase3. Inflation expectations rise from 3% to 6%4. The Fed increases interest rates with contractionary monetary policy5. Inflation expectations fall from 5% to 2%6. The government increases income taxes7. What happens in the LONG RUN in Question #1?
