The Phillips Curve Unemployment vs. Inflation Managing the short run trade-off

Employment & Inflation Full Employment level depends on each country’s features of labor market: Including: minimum-wage laws, the market power of unions, the effectiveness of job search (think internet), & other labor laws etc…. In USA = 4.5% Inflation rate depends on growth in the quantity of money Supply of money is controlled by the Federal Reserve

Fiscal Policy: short run trade off If policymakers ↑ AD, they can lower unemployment, but with the cost of higher inflation If they ↓ AD, they can lower inflation, but with the cost of temporarily higher unemployment

Short Run Phillips Curve % Unemployment Rate 0 % Inflation Rate Short Run Phillips curve 4 B 6 7 A 2

SRAS & Short Run Phillips Curve Real GDP or Output 0 SRAS AS/AD Model Unemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level Short Run Phillips Curve SRPC AD 1 AD 2 (output is 8,000) B 4 6 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7, A 1) Movements along SRAS => movements along SRPC 2) Shifts in SRAS => SRPC shifts in opposite direction

The Long-Run Phillips Curve In the 1960s, Friedman & Phelps concluded that inflation & unemployment are unrelated in long run In the long run, Inflation is only related to the Quantity Of Money (Money Supply) Therefore, the Long-Run Phillips curve is vertical at full employment

The Long-Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve B High inflation Low inflation A but unemployment remains at its natural rate in the long run. 1. When the Fed increases Money supply The rate of inflation rises

LRAS & Long Run Phillips Curve Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level P AD 1 LRASLRPC AS/AD Model Unemployment Rate 0 Inflation Rate Long Run Phillips Curve raises the price level An decrease in Taxes increases Aggregate demand. A AD 2 B A but leaves output and unemployment at their natural rates and increases the inflation rate... P2P2 B

Conclusion In long run, expected inflation adjusts to changes in actual inflation –So fiscal policy is not effective in lowering unemployment only in increasing inflation Fed can only create unexpected inflation in short run –Once people anticipate inflation, they adjust. –Only way to get unemployment below the natural rate is for actual inflation to be above anticipated inflation

Inflation Unemployment SRPC