Short-run Policy Tradeoff Chapter 17

Short-run Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate in the short run –Assuming the natural rate of unemployment and the expected inflation rate is unchanged. –It shows tradeoff between inflation and unemployment (The lower inflation rate, the higher rate of unemployment). New Zealand economist Phillips discovered this relationship from the 100 years U.K. data in 1958.

Short-run Phillips Curve Continued Okun’s law –For every percentage point that the unemployment rate is above the natural rate of unemployment, there is two percent gap between real GDP and potential GDP. The short-run Phillips curve is another way of presenting the AS curve. Shift of the short-run Phillips curve –Caused by changes in the natural rate of unemployment or expected inflation rate.

Long-run Phillips Curve A vertical line the relationship between the inflation rate and the unemployment rate in the long run –Assuming the economy is at full employment. –It shows no tradeoff between inflation and unemployment. Any attempt to lower unemployment below the natural rate will only result in higher inflation without success in lowering unemployment in the long run.

Natural Rate Hypothesis The proposition that any change in unemployment due to money supply growth is only temporary and eventually the natural rate of unemployment prevails. Money supply growth  expected inflation rate increase, and the short-run Phillips curve shifts up (or rightward). So, tradeoff along the short-run Phillips curve is temporary. No tradeoff along the long-run Phillips curve.

Natural Unemployment Rate Does it change? Yes. –Increase in the 70s due to the baby boom generation entering the labor force and the oil crises. –Decrease in the 80s and 90s due to the baby bust generation entering the labor force and technology innovation What happens to the Phillips curve? –Both the short-run and long-run Phillips curves shift rightward.

Expected Inflation Rate What is it? –The inflation rate that people forecast and use to set the money wage and other money price What determines it? –Past inflation and the Fed’s monetary policy –People have rational expectation Using all the relevant data and economic science What happens to the Phillips curve? –Gradual shift of the short-run Phillips curve How to lower expected inflation? –By lowering actual inflation rates over time. Surprise reduction vs. credible announced reduction