Disinflationary Monetary Policy n In the long-run the actual inflation rate becomes the expected rate causing the AS curve and the Phillips curve to shift. n If monetary or fiscal policy increases AD then in the short-run price levels/inflation rise and output increases and unemployment decreases. n In the long-run inflationary expectations rise to meet the actual inflationary levels (employees ask for wage increases) and the AS curve and the PC curve shift.
AS 2 1. An adverse shift in aggregate supply… An Adverse Shock to Aggregate Supply... Quantity of Output 0 Price Level P1P1 Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 (b) The Phillips Curve A Inflation Rate Phillips curve, PC 1 Aggregate supply, AS 1 A Y1Y1 P2P2 3. …and raises the price level… B 2. …lowers output… Y2Y2 B 4. …giving policymakers a less favorable tradeoff between unemployment and inflation. PC 2
The Cost of Reducing Inflation u The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. u An estimate of the sacrifice ratio is five. u To reduce inflation from about 10% in 1979-1981 to 4% would have required an estimated sacrifice of 30% of annual output!