Module 34 Inflation and Unemployment: The Phillips Curve

Module 34 Essential Questions What is the Phillips curve and the nature of the short-run trade-off between inflation and unemployment? Why is there no long-run trade-off between inflation and unemployment? Why are expansionary policies limited due to the effects of expected inflation? Why are even moderate levels of inflation hard to end? Why is deflation a problem for economic policy? How does this lead policy makers to prefer a low but positive inflation rate?

The Short-Run Phillips Curve Phillips Curve: shows relationship between inflation & unemployment Short-Run Phillips Curve: SRPC The role of supply shocks

The Short-Run Phillips Curve Explained (Graphs Help Here) Short-run trade-off between unemployment & inflation: Lower unemployment = higher inflation Higher unemployment = lower inflation This concept is represented by the graph known as the Phillips curve! When AD increases along the SRAS, the unemployment rate falls and the inflation rate rises… When AD decreases along the SRAS, the unemployment rate rises and the inflation rate falls…   A shift in AD will cause a movement along the SRPC. This is what causes a downward sloping relationship between the unemployment rate and the inflation rate. This is known as the short-run Phillips curve. When SRAS increases along the AD (different graph remember?), both the unemployment and inflation rates fall. This is seen as a downward shift of the SRPC. When SRAS decreases along the AD, both the unemployment and inflation rates rise. This is seen as an upward shift of the SRPC.

The Short-Run Phillips Curve Drawn When SRAS increases along the AD (draw this graph), both the unemployment and inflation rates fall. This is seen as a downward shift of the SRPC. Draw this graph.   When SRAS decreases along the AD (draw this graph), both the unemployment and inflation rates rise. This is seen as an upward shift of the SRPC. Draw this graph.

Inflation Expectations & the Short-Run Phillips Curve Expected Inflation? Relationship between actual and expected inflation? What determines expected inflation?

Inflation Expectations & the Short-Run Phillips Curve Explained What is the expected rate of inflation? Why does it matter? This is why an increase in expected inflation shifts the short­ -­ run Phillips curve upward: the actual rate of inflation at any given unemployment rate is higher when the e______________inflation rate is higher.

Inflation Expectations & the Short-Run Phillips Curve Explained What is the expected rate of inflation? Why does it matter? Inflation that employers & workers expect in the near future. Changes will affect the short­-run trade­-­off between unemployment and inflation & shift the short-run Phillips curve. Everyone cares about future inflation. If inflation is expected to be high in the future, wage contracts will reflect that expectation & nominal wages will be increased. Nobody wants to lose purchasing power due to future inflation!!   This is why an increase in expected inflation shifts the short­ -­ run Phillips curve upward: the actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher.

Inflation Expectations & the Short-Run Phillips Curve Explained Why is this so?? Higher inflation expectations shift the SRPC upward. At any level of unemployment, inflation will be that much higher. And lower inflation expectations shift the SRPC downward.

Inflation Expectations & the Short-Run Phillips Curve Explained Why is this so?? Suppose inflation has been near zero for years, but gradually people begin to expect inflation of 3%. Nominal wages & other contracts begin to reflect a future increase of 3%. As these wages and other resource prices rise by 3%, actual inflation begins to rise from about zero to 3%. So inflation expectations translate into actual inflation rates. Higher inflation expectations shift the SRPC upward. At any level of unemployment, inflation will be that much higher. And lower inflation expectations shift the SRPC downward.

Inflation and Unemployment in the Long Run The SRPC of the 1960s The experience of the 1970s The trade-off between inflation & unemployment? Most macroeconomists believe that there is, in fact, no long-run trade-off between lower unemployment rates and higher inflation rates. That is, it is not possible to achieve lower unemployment in the long run by accepting higher inflation.

Long-Run Phillips Curve Illustrated p. 336 The unemployment rate at which inflation does not change over time—5% in this graph, is known as the non-accelerating inflation rate of unemployment, or NAIRU for short. Keeping the unemployment rate below the NAIRU leads to ever­-­accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long­-­run trade­-­off between unemployment and inflation. The short run and long run effects of expansionary policies

The Long-Run Phillips Curve NAIRU LRPC Natural Rate Hypothesis Natural Rate = NAIRU

The Costs of Disinflation Explained An effort to reduce unemployment below NAIRU will cause inflation. What about an effort to reduce inflation? The government must create a situation, with contractionary fiscal/monetary policy, where the unemployment rate is above NAIRU. This induced recession, should decrease the inflation rate to the point where the SRPC shifts downward. Once inflation is under control, the economy can adjust back to the NAIRU. This process of disinflation is painful because of a period of high unemployment.

The Costs of Disinflation Illustrated

Deflation Deflation? Debt Deflation? Effects of Expected Deflation? Zero Bound? Liquidity Trap?

Deflation: Falling Aggregate Price Level Debt Deflation Due to the falling price level, a dollar in the f__________ has a higher real value than a dollar t________. Lenders, who are owed money, g________under deflation because the real value of borrowers’ payments increases. Borrowers l________ because the real burden of their debt rises.   What do you expect borrowers to do? Effects of Expected Deflation   Interest rates are affected by inflation e_____________. What about deflation? Nominal rate = r_______ rate + expected i__________ Suppose the rr=2% and expected inflation = 3%, then the nominal rate = 5%. But what if there is prolonged deflation and expected inflation is -2%, the nominal rate is 0%?

Deflation: Falling Aggregate Price Level Debt Deflation Due to the falling price level, a dollar in the future has a higher real value than a dollar today. Lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises.   What do you expect borrowers to do? Cut back on spending. So weak spending causes deflation, which causes less spending, which causes deflation…. Effects of Expected Deflation   Interest rates are affected by inflation expectations. What about deflation? Nominal rate = real rate + expected inflation Suppose the rr=2% and expected inflation = 3%, then the nominal rate = 5%. But what if there is prolonged deflation and expected inflation is -2%, the nominal rate is 0%?

Deflation: Falling Aggregate Price Level Interest rates cannot fall below 0%. So deflation creates a situation where lenders receive nominal interest rates that approach zero. Lending will stop. WHY? This is referred to as the l__________trap.

Deflation: Falling Aggregate Price Level Interest rates cannot fall below 0%. So deflation creates a situation where lenders receive nominal interest rates that approach zero. Lending will stop. WHY? If the economy is extremely depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective. The Fed can’t lower the interest rate lower than 0%!! This kind of deflation can cause an economy to languish for a very long time. This is referred to as the liquidity trap.

Module 34 Review Questions p. 341-342 Read Module 35 p. 343-353