1. Chapter 5

2.  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.”

3.  “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).

4.  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) (A) Y P SRAS AD 1 AD 2 Y1Y1 103 A 105 Y2Y2 B u-rate inflatio n PC 6% 3% A 4% 5% B

5.  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

6.  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

7.  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

8. Y P LRAS AD 1 AD 2 Natural rate of output P1P1 P2P2 u-rate Inflatio n Natural rate of unemployment LRPC low inflatio n high inflation

9.  Since the LRAS curve is vertical, and output stays constant, any increase in AD just increases Inflation.

10.  Expected Inflation:  Measure of how much people expect the overall PL to change

11.  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

12. 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.

13.  Natural-Rate Hypothesis:  Claims that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation

14.  Supply shock : an event that directly alters firms’ costs and prices, shifting the AS and PC curves  Example: large increase in oil prices

15. Y P SRAS 1 ADAD SRAS 2 A Y1Y1 P1P1 Y2Y2 B P2P2 U-Rate Inflatio n PC 1 PC 2 A B

16.  SRAS Curve shifts left:  Output decreases  Price level increases  Unemployment rises

17.  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

18.  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

19.  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.