1. Chapter 35 - The Short-Run Trade-off between Inflation and Unemployment
Phillips curve - shows the short-run trade-off between inflation and unemployment
Inverse relationship, negative correlation between the rate of unemployment and the rate of inflation
Important to policymakers relative to monetary and fiscal policy when they attempt to influence aggregate demand
Initially, policymakers assumed it offered a menu of options, choose any point on Phillips curve to control unemployment
Trade-off: High unemployment and low inflation or low unemployment and high inflation

2. The Phillips Curve Inflation Rate (percent per year) B 6% A 2%4% B 6% 7% A 2%
Unemployment
Rate (percent)
The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and unemployment is low.

3. The Phillips Curve
Aggregate demand (AD), aggregate supply (AS), and the Phillips curve
Shifts in the aggregate-demand curve push inflation and unemployment in opposite directions in the short run
Higher aggregate-demand
Higher output & Higher price level
Lower unemployment & Higher inflation
Lower aggregate-demand
Lower output & Lower price level
Higher unemployment & Lower inflation

4. How the Phillips curve is related to the model of aggregate demand and aggregate supply
(a) The Model of AD and AS
(b) The Phillips Curve
Inflation
Rate
(percent
per year)
Price
level
SRAS
AD2
Phillips curve
106 B 4%
output
=16,000 B
AD1 6%
16,000
unemployment
=4%
102 A 7%
output
=15,000 A 2
15,000
unemployment
=7%
Quantity
of output
Unemployment
Rate (percent)

5. Long-Run Phillips Curve
The long-run Phillips curve is vertical
Unemployment - does not depend on money growth and inflation in the long run
We always return to the “natural rate of unemployment”, but at a higher price level
If the Fed increases the money supply
In the short run, unemployment will fall, but inflation rate is high
In the long run unemployment will return to its natural rate
Inflation
Rate
Long-run
Phillips curve
Natural rate of
unemployment
High
inflation B
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
but unemployment
remains at its natural rate
in the long run.
Low
inflation A
Unemployment
Rate

6. Long-Run Phillips Curve
The long-run Phillips curve is the expression of the classical idea of monetary neutrality
Increase in money supply
Interest rates decline and the aggregate-demand curve – shifts right
Price levels (inflation) increase and unemployment decreases in the short-run
Long-run – people come to expect inflation and output returns to natural rate, along with unemployment

7. Long-Run Phillips Curve and LRAS
The economy experiences a boom, people have more disposable income to spend
Price
Level
Inflation
Rate
Unemployment
Rate
Quantity of Output (Real GDP)

8. Long-Run Phillips Curve and LRAS
The economy experiences a boom in the stock market, people have more disposable income to spend
Price
Level
LRPC Yf 5%
LRAS Yf
SRAS2
Inflation
Rate
SRAS1
SRPC2 P3 C C 9%
SRPC 3% B P2 B 6% P1 A Y2 A 3%
AD2
AD1
Unemployment
Rate
Quantity of Output (Real GDP)

9. Long-Run Phillips Curve and LRAS
The economy experiences a recession due to reductions in AD.
Price
Level
Inflation
Rate
Unemployment
Rate
Quantity of Output (Real GDP)

10. Long-Run Phillips Curve and LRAS
The economy experiences a recession due to reductions in AD.
LRPC Yf 5%
Price
Level
LRAS Yf
Inflation
Rate
SRAS1
SRPC
SRAS2 P1 A
SRPC2 A 3% 8% B 2% P2 B C Y2 P3 C 1%
AD2
AD1
Unemployment
Rate
Quantity of Output (Real GDP)

11. Long-Run Phillips Curve and LRAS
Scenario: The government adopts expansionary fiscal policy because of political pressures and cuts taxes. Show how shifts in the AD curve will affect the Phillips curve. Use 2% as the equilibrium inflation rate and 5% as the natural rate of unemployment. Use 5% inflation after the economy experiences the increase in AD. To fix the inflation problem, the government raises taxes back to their normal rate
Price
Level
LRAS Yf
LRPC Yf 5%
Inflation
Rate
SRAS1
SRPC P2 B 3% B 5% P1 A Y2 A 2%
AD2
AD1
Unemployment
Rate
Quantity of Output

12. Long-Run Phillips Curve and LRAS
Scenario: The government adopts expansionary fiscal policy because of political pressures and cuts taxes. Show how shifts in the AD curve will affect the Phillips curve. Use 2% as the equilibrium inflation rate and 5% as the natural rate of unemployment. Use 5% inflation after the economy experiences the increase in AD. To fix the inflation problem, the government raises taxes back to their normal rate
Price
Level
Inflation
Rate
Unemployment Rate
Real GDP
(Quantity of Output)

13. Long-Run Phillips Curve and LRAS
Scenario: Assume long run equilibrium. There is an embargo placed on the United States by OPEC nations. Show how shifts in the SRAS curve will affect the Phillips curve. The government increases spending to get unemployment and production back to its natural rate.
Price
Level
LRAS Yf
LRPC Yf 5%
SRAS2
Inflation
Rate
SRAS1
SRPC2 C P3 C 9% Y2 7% B
SRPC P2 B 5% P1 A Y2 A 2%
AD2
AD1
Quantity of Output UR

14. Long-Run Phillips Curve and LRAS
Scenario: Assume long run equilibrium. There is an embargo placed on the United States by OPEC nations. Show how shifts in the SRAS curve will affect the Phillips curve. The government increases spending to get unemployment and production back to its natural rate.
Price
Level
Inflation
Rate
Real GDP
(Quantity of Output)
Unemployment Rate

15. Shifts in Phillips Curve: Role of Expectations
Rational Expectations – people will adjust their behavior to expectations of inflation.
Shifts in AD causes movement along the short-run Phillips curve
Shifts to the right cause inflation to increase and unemployment to decrease
Shifts to the left cause inflation to decrease and unemployment to increase

16. Shifts in Phillips Curve: Role of Expectations
Shifts in SRAS cause a shift in the SRPC
Shifts to the right in SRAS cause shifts to the left in the SRPC
Shifts to the left in SRAS cause cause shifts to the right in the SRPC
SRAS and SRPC are mirror images of each other

17. Long-Run Phillips Curve Application
Scenario: A country’s economy is in a short-run equilibrium with an output level less than the full- employment output level.(recession). Assume an upward-sloping aggregate supply curve. (a) Using a correctly labeled aggregate demand and aggregate supply graph, show the following. (i) Full-employment output, labeled as YF (ii) Equilibrium real output and price level, labeled as YE and PLE, respectively (b) Assume that the country’s government increases domestic military expenditures. On the graph from part (a), show how the increased military expenditures affect the following in the short run. (i) Aggregate demand (ii) Equilibrium real output and price level, labeled as Y2 and PL2, respectively (c) Using a correctly labeled graph of the short-run Phillips curve, show the effect of the increased military expenditures in the short run, labeling the initial point as A and the new point as B.

18. Long-Run Phillips Curve Application
Scenario: 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.
(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.

19. Long-Run Phillips Curve Application
The unemployment rate in the country of Southland is greater than the natural rate of unemployment.
(a) Using a correctly labeled graph of aggregate demand and aggregate supply, show the current equilibrium real gross domestic product, labeled YC, and price level in Southland, labeled PLC. The president of Southland is receiving advice from two economic advisers—Kohelis and Raymond—about how best to reduce unemployment in Southland.
(b) Kohelis advises the president to decrease personal income taxes.
(i) How would such a decrease in taxes affect aggregate demand? Explain.
(ii) Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in taxes.
Label the initial equilibrium from part (a) as point A, and the new equilibrium resulting from the decrease in taxes as point B.
(c) Raymond advises the president to take no policy action.
(i) What will happen to the short-run aggregate supply curve in the long run? Explain.
(ii) Using a new correctly labeled graph of the short-run Phillips curve, show the effect of the change in the short-run aggregate supply you identified in part (c)(i).

21. Chapter 35 Mankiw Application Worksheet
Describe the initial effect of the following events on the short-run and long-run Phillips curve. That is, describe the movements along a given curve or the direction of the shift in the curve.
An increase in expected inflation causes people to demand higher wages causing firms to decrease production
Shifts short-run Phillips curve to the right (upward).
An increase in the price of imported oil
An increase in the money supply causing unexpected inflation
Movement along and up the short-run Phillips curve.
A decrease in government spending
Movement along and down the short-run Phillips curve.
A decrease in the minimum wage, which lowers the natural rate unemployment
Long-run and short-run Phillips curves shift left (downward).

22. Chapter 35 Mankiw Application Worksheet
At what point is the economy located if people expect 10 percent inflation and inflation actually is 10 percent?
Answer: E
Referring to (a) above, is unemployment above, below, or equal to the natural rate?
Equal to the natural rate.
At what point is the economy located if people expect 10 percent inflation and the actual rate of inflation is 15 percent?
Answer: D.
Suppose the economy is operating at point D. Over time, in which direction will people revise their expectations of inflation: up or down?
Answer: Up.
Suppose the economy is operating at point D. As people revise their expectations of inflation, in which direction will the short-run Phillips curve shift-right or left?
Answer: Right.
Suppose the economy is operating at point E. In the short run, a sudden decrease in aggregate demand will move the economy toward which point?
Answer: F.
Suppose the economy is operating at point E. In the long run, a decrease in government spending will tend to move the economy toward which point?
Answer: H.
Suppose people expect 5 per cent inflation. If inflation actually ends up being 10 per cent, in which direction will unemployment move: above or below the natural rate?
Answer: Below the natural rate.

23. Chapter 35 Mankiw Application Worksheet
3. Use a Phillips curve graph to answer the following questions. Assume the economy is initially in long-run equilibrium.
What happens to an economy’s unemployment and inflation rate in the short run if the central bank increases the growth rate of the money supply
Answer: Inflation increases, unemployment decreases.
What happens to an economy’s unemployment and inflation rate in the long run if the central bank increases the growth rate of the money supply
Answer: Inflation increases, unemployment stays at the natural rate.
Can printing money keep unemployment below the natural rate? Explain.
Answer: No. Unemployment temporarily decreases, but as people grow to expect the higher inflation, unemployment returns to the natural rate.
What is the end result of a central bank repeatedly attempting to hold unemployment below the natural rate with expansionary monetary policy? Explain.
Answer: Continued attempts to move unemployment below the natural rate simply causes inflation.

24. 2011

26. (ii)One point is earned for stating that the Federal Reserve should buy bonds.
(iii) Price level will increase because the Federal Reserve action increases interest-sensitive spending (e.g., investment and consumption) and aggregate demand.

27. • One point is earned for stating that the short-run aggregate supply will increase (shift right) because wages and other input prices will decrease.
• One point is earned for stating that the natural rate of unemployment remains unchanged.

28. 2011 (B)

29. 2011 (B)

30. 2011 (B)
One point is earned for stating that transfer payments will increase because more people will apply for government benefits.

31. 2011 (B)

32. 2011 (B)
One point is earned for stating that the short-run aggregate supply curve will shift to the right because wages and other input costs will fall.

33. 2010

35. • One point is earned for stating that investment spending will decrease.
• One point is earned for explaining that the decrease in investment slows down capital deepening, leading to a reduction in the economic growth rate.

36. Free Responses
2005
2006 (1)
2006 (3)
2006 b
2008
2009 (a)
2009 (b)

37. Binder Check Monetary and Fiscal Policy Scenarios
Free Response Station Work
Daily Tens
Terms
Notes

38. Upcoming Assignments
3 Online lecture videos and quizzes – due Thursday.
Prequiz, Chapters due Friday.

39. One point is earned for the correct calculation of the real interest rate: 8% - 6% = 2%.

40. One point is earned for stating that the Federal Reserve should sell bonds.

41. One point is earned for stating that aggregate demand decreases.
One point is earned for explaining that the higher interest rate decreases investment and interest-sensitive consumption spending, and that both consumption and investment are components of aggregate demand.

42. • One point is earned for stating that the short-run Phillips curve will shift to the left, or movement along the curve towards recessionary conditions.
• One point is earned for explaining that Federal Reserve policy will lower inflationary expectations so the economy will slow.
• One point is earned for stating that the natural rate of unemployment will remain unchanged in the long-run.