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7/29/2019 Philips Curve1
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Short Run Trade Off Between
Inflation and Unemployment
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Unemployment and Inflation
The natural rate of unemployment depends onvarious features of the labor market.
Examples include minimum-wage laws, themarket power of unions, the role of efficiencywages, and the effectiveness of job search.
The inflation rate depends primarily on growthin the quantity of money, controlled by the RBI.
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Trade Off
Society faces a short-run tradeoff betweenunemployment and inflation.
If policymakers expand aggregate demand, theycan lower unemployment, but only at the cost ofhigher inflation.
If they contract aggregate demand, they can
lower inflation, but at the cost of temporarilyhigher unemployment.
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Phillips Curve A W Phillips- New Zealand Economist Analyzed statistical data concerning unmpt %
and wage % in Britain during the period 1861 to
1957. Found that wage rate rose rapidly when
unemployment was low; decreased when it washigh
ThePhillips curve illustrates the short-runrelationship between inflation andunemployment.
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The Phillips Curve
UnemploymentRate (percent)0
InflationRate
(percentper year)
Phillips curve4
B6
7
A
2
Copyright 2004 South-Western
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THE SHORT-RUN PHILLIPS CURVE
The naturalunemployment rate
is 6 percent.
This combination,at point B, providesthe anchor pointfor the short-runPhillips curve.
The expectedinflation rate is 3
percent a year.
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AD, AS, and Phillips Curve
The Phillips curve shows the short-runcombinations of unemployment and inflation
that arise as shifts in the aggregate demandcurve move the economy along the short-runaggregate supply curve. The greater theaggregate demand for goods and services, the
greater is the economys output, and the higher
is the overall price level. A higher level of output results in a lower level of
unemployment.
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Quantityof Output0
Short-runaggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
UnemploymentRate (percent)0
InflationRate
(percent
per year)
PriceLevel
(b) The Phillips Curve
Phillips curveLow aggregate
demand
Highaggregate demand
(output is8,000)
B
4
6
(output is7,500)
A
7
2
8,000(unemployment
is 4%)
106 B
(unemploymentis 7%)
7,500
102 A
Copyright 2004 South-Western
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Phillips curve- inverse relation Rate of wage inflation decreases with the
unemployment rate. Rate of wage inflation,
gw= Wt+1Wt/Wtgw = - (u-un)
Implies that wages will fall when the actualunemployment rate exceeds the natural rate
Will rise when actual unemployment rate isbelow the natural rate.
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The inverse relation- reasons
Relative bargaining strength of trade unions andmanagement
Generalized excess demand for labour Imbalances b/w supply and demand in labour
market.
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Phillips curve that Economists use today differsin three ways from the relationship Phillips
examined Modern Phillips curve substitutes price inflation
for wage inflation Includes expected inflation Includes supply shocks
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Long-Run Phillips Curve
In the 1960s, Friedman and Phelps concludedthat inflation and unemployment are unrelated
in the long run. As a result, the long-run Phillips curve is vertical
at the natural rate of unemployment. Monetary policy could be effective in the short run
but not in the long run.
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The Long-Run Phillips Curve
UnemploymentRate0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
BHighinflation
Lowinflation
A2. . . . but unemploymentremains at its natural ratein the long run.
1. When theRBI increasesthe growth rateof the money
supply, therate of inflationincreases . . .
Copyright 2004 South-Western
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Quantityof OutputNatural rateof output Natural rate ofunemployment0
PriceLevel
PAggregate
demand, AD
Long-run aggregatesupply Long-run Phillipscurve
(a) The Model of Aggregate Demand and Aggregate Supply
UnemploymentRate0
InflationRate
(b) The Phillips Curve
2. . . . raisesthe pricelevel . . .
1. An increase in
the money supplyincreases aggregatedemand . . .
AAD2
B
A
4. . . . but leaves output and unemploymentat their natural rates.
3. . . . andincreases theinflation rate . . .
P2 B
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Expectations and Short-Run PhillipsCurve Expected inflation measures how much people
expect the overall price level to change.
In the long run,expected inflation adjusts tochanges in actual inflation. The Feds ability to create unexpected inflation
exists only in the short run. Once people anticipate inflation, the only way to
get unemployment below the natural rate is foractual inflation to be above the anticipated rate.
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Formula
Unemployment Rate=Natural Rate ofUnemployment- a {Actual Inflation Expected
Inflation}
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How Expected Inflation Shifts the Short-RunPhillips Curve
UnemploymentRate
0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
Short-run Phillips curvewith high expected
inflationShort-run Phillips curve
with low expectedinflation
1. Expansionary policy movesthe economy up along the
short-run Phillips curve . . .
2. . . . but in the long run, expectedinflation rises, and the short-runPhillips curve shifts to the right.
CB
A
Copyright 2004 South-Western
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Shifts in Short-Run Phillips Curve
The short-run Phillips curve also shifts becauseof shocks to aggregate supply.
Major adverse changes in aggregate supply canworsen the short-run tradeoff betweenunemployment and inflation.
An adverse supply shock gives policymakers a lessfavorable tradeoff between inflation andunemployment.
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An Adverse Shock to Aggregate Supply
Quantityof Output0
PriceLevel
Aggregatedemand
(a) The Model of Aggregate Demand and Aggregate Supply
UnemploymentRate0
InflationRate
(b) The Phillips Curve
3. . . . andraisesthe pricelevel . . .
AS2 Aggregatesupply,
AS
A1. An adverseshift in aggregatesupply . . .
4. . . . giving policymakersa less favorable tradeoffbetween unemploymentand inflation.
BP2
Y2
P A
Y Phillips curve,PC
2. . . . lowers output . . .
PC2
B
Copyright 2004 South-Western
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Cost of Reducing Inflation To reduce inflation, the Fed has to pursue contractionary
monetary policy. When the Fed slows the rate of money growth, it contracts
aggregate demand. This reduces the quantity of goods and services that firms
produce. This leads to a rise in unemployment. To reduce inflation, an economy must endure a period of high
unemployment and low output. When the Fed combats inflation, the economy moves down the
short-run Phillips curve. The economy experiences lower inflation but at the cost of higher
unemployment.
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Disinflationary Monetary Policy in the Short Run andthe Long Run
UnemploymentRate0 Natural rate ofunemployment
InflationRate Long-run
Phillips curve
Short-run Phillips curvewith high expected
inflation
Short-run Phillips curvewith low expected
inflation
1. Contractionary policy movesthe economy down along the
short-run Phillips curve . . .
2. . . . but in the long run, expectedinflation falls, and the short-run
Phillips curve shifts to the left.
BC
A
Copyright 2004 South-Western
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Sacrifice Ratio
The sacrifice ratio is the number of percentagepoints of annual output that is lost in the process
of reducing inflation by one percentage point. An estimate of the sacrifice ratio isfive.
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Rational Expectations and Possibility ofCostless Disinflation The theory ofrational expectations suggests that people
optimally use all the information they have, includinginformation about government policies, when forecasting the
future. Expected inflation explains why there is a tradeoff between
inflation and unemployment in the short run but not in the longrun.
How quickly the short-run tradeoff disappears depends on how
quickly expectations adjust. The theory of rational expectations suggests that the sacrifice-
ratio could be much smaller than estimated.