Copyright © 2004 South-Western The Unemployment- Inflation Relationship— the Phillips Curve Mod 34

Copyright © 2004 South-Western Remember the output gaps: Negative Gap Remember that when the Economy is operating BELOW LRAS, there is an output gap. It is a negative gap—called a Recessionary Gap—the difference between what AD is and where it could be at full potential. This means there is higher unemployment and lower price levels.

Copyright © 2004 South-Western Remember the output gaps: Positive Gap Remember that when the Economy is operating ABOVE LRAS, there is an output gap. It is a positive gap—called an Inflationary Gap—the difference between what AD is and where it could be at full potential. This means there is lower unemployment and higher price levels.

Copyright © 2004 South-Western The Short-Run Phillips Curve The Short-Run Phillips Curve shows the trade-off between Inflation and Unemployment that is evident on the AD/AS graph. It is as if we are looking “underneath” the AD/AS graph to see this aspect of things. Read the graph—The higher the inflation rate, the lower the unemployment rate. The higher the unemployment rate, the lower the inflation rate.

Copyright © 2004 South-Western Phillips Curves in the Long Run In the long run, the economy will settle at the natural rate of unemployment, the unemployment rate where there is no cyclical unemployment. Therefore, in the long run there is no relationship between inflation and unemployment. Inflation Rate Unemployment Rate LRP C Natura l Rate

Copyright © 2004 South-Western Short-hand for Phillips Curve Changes and Shifts When AD shifts, you move along the Phil Curve AD increase—move up and left AD decrease—move down and right When SRAS shifts, Phil Curve shifts SRAS increase—shift to left SRAS decrease—shift to right

Copyright © 2004 South-Western Phillips Curve Shifts PLPL RGDP SRAS 2 Inflation Rate Unemployment Rate SRPC 1 SRPC 2 PL is lower at every output level Inflation is lower at each unemployment rate RGDP and employment are higher at each PL Unemployment is lower at each inflation rate Unemployment is lower at each PL

Copyright © 2004 South-Western Phillips Curve Shifts SRAS would shift to the left: SRPC would shift to the right: PLPL RGD P SRAS 2 SRAS 1 Inflation Rate Unemployment Rate SRPC 2 SRPC 1 PL is higher at every output level Inflation is higher at each unemployment rate RGDP and employment are lower at each PL Unemployment is higher at each inflation rate Unemployment is higher at each PL

Let’s see what you have learned!

Copyright © 2004 South-Western Multiple Choice Question According to the short-run Phillips Curve, a decrease in unemployment is expected to be accompanied by (A) higher labor- force participation rate (B) an increase in inflation (C ) an increase in the productivity of capital (D) an increase in the government deficit (E) a decrease in real gross domestic product Answer is B

Copyright © 2004 South-Western Multiple Choice Question According to the-long run Phillips curve, which of the following is true? (A) Unemployment increases with an increase in inflation. (B) Unemployment decreases with an increase in inflation (C ) Increased automation will lead to lower levels of structural unemployment in the long run. (D) Changes in the composition of the overall demand for labor tend to be deflationary in the long run. (E) The natural rate of unemployment is independent of monetary and fiscal policy changes that affect aggregate demand. Answer is E

Copyright © 2004 South-Western FRQ 3. Inflation and expected inflation are important determinants of economic activity. (a)Draw a correctly labeled graph of a short-run Phillips curve. (b) Using your graph in part (a), show the effect of an increase in the expected rate of inflation. (c) What is the effect of the increase in the expected rate of inflation on the long-run Phillips curve?

Copyright © 2004 South-Western FRQ ANSWER a) 1 point: One point is earned for drawing a correctly labeled graph of the short-run Phillips curve. (b) 1 point: One point is earned for shifting the short-run Phillips curve to the right. (c) 1 point: One point is earned for stating that the increase in expected inflation does not affect the long-run Phillips curve.

Copyright © 2004 South-Western FRQ 1.Assume that the United States economy is in long- run equilibrium with an expected inflation rate of 6 percent and an unemployment rate of 5 percent. The nominal interest rate is 8 percent. (a)Using a correctly labeled graph with both the short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A. (b) Assume that the Federal Reserve action (targeting a 3% inflation rate) is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium? (i) The short-run Phillips curve. Explain. (ii) The natural rate of unemployment.

Copyright © 2004 South-Western FRQ ANSWER

Copyright © 2004 South-Western FRQ ANSWER (b) 3 points: One point is earned for stating that the short-run Phillips curve will shift to the left. One point is earned for explaining that Federal Reserve policy will lower inflationary expectations. One point is earned for stating that the natural rate of unemployment will remain unchanged.

Copyright © 2004 South-Western FRQ 1. Assume the United States economy is operating at full-employment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recession. (a) Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in consumption spending. Label the initial position “A” and the new position “B”.

Copyright © 2004 South-Western FRQ ANSWER