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potential output (Yp)
the level of RGDP the economy would produce once all prices (wages) fully adjust
slowly grows over time (LR growth)
actual a.o. will differ from Yp in SR (output gap)
t or f: in the event of an output gap, we can infer that prices haven’t adjusted.
t
unemployment equation
CU + NU
2 rules of the relationship between unemployment and the output gap
a.o. = Yp when UR = NU
a. fluctuations of a.o. around Yp correspond to changes in UR around NU
in a + output gap (inflationary), UR < NU; in a - output gap (recessionary), UR > NU
how are resources used in recessionary and inflationary gaps?
recessionary: resources not used to full potential → high UR
inflationary: resources used at higher-than-normal rates → low UR
short-run trade-off between unemployment and inflation
low unemployment and high inflation or high unemployment and low inflation
policymakers utilize this trade-off to alter UR/IR with MP/FP
short-run Phillips curve (SRPC)
represents the negative short-run relationship between the UR and the inflation rate
y-axis: inflation rate
x-axis: UR
Okun’s law
a 1% increase in the output gap → 0.5% decrease in the UR
what causes movements along the SRPC?
demand shocks (changes in AD)
shifters of the SRPC
supply shocks (- shock → upward shift, + shock → downward shift)
expected inflation rate (an increase → shift up)
the most important factor affecting inflation
expected inflation rate
expected inflation rate
the inflation rate that workers and employers expect in the near future
increase → upward shift
t or f: changes in the expected inflation rate and the actual inflation rate aren’t one-to-one.
f
t or f: the trade-off between unemployment and the inflation rate still exists in the long run.
f: in LR, consistent inflation is already included in the expectations of the public, so there’s no trade-off
a persistent attempt to trade off low UR for high inflation causes ______ inflation.
accelerating
to avoid this, the UR must be high enough that actual inflation = expected inflation
nonaccelerating inflation rate of unemployment (NAIRU)
the UR at which inflation does not change over time (another word for the natural rate of unemployment)
keeping a UR < NAIRU → accelerating inflation
keeping a UR > NAIRU → decelerating inflation
long-run Phillips curve (LRPC)
shows the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience
it is a vertical line, since any UR above/below NAIRU can’t be maintained in the long run
UR below NAIRU → i gap (and vice-versa)
why is bringing inflation down much harder than increasing it?
the public has already expected continual inflation (it’s become a crucial part of expectations) + high unemployment will occur
disinflation
the process of bringing down inflation that has already become embedded in expectations
needs contractionary policies
causes a short-term loss, but long-term gain
believed the costs of disinflation can be reduced if policymakers explicitly tell the public their plans of disinflation (can reduce inflationary expectations to shift SRPC down)
goal: UR right above NAIRU
in the case of unexpected inflation/deflation, who wins and loses in a loan?
deflation: borrowers lose, lenders win
inflation: borrowers win, lenders lose
how does deflation worsen economic slumps?
it takes real resources away from borrowers and redistributes them among lenders
borrowers (losers) become low on cash due to an increased debt burden → cutting spending fast
lenders (winners) gain value on their loans, so they’re less likely to increase spending
debt deflation
the effect of deflation in decreasing AD
t or f: expected inflation affects the NIR, but not deflation.
f: both affect the NIR, since deflation is just a negative expected inflation
NIR = RIR + expected inflation
zero bound
the NIR cannot be less than zero
once it is, people would rather hold onto money than lend it out
liquidity trap
a situation in which conventional MP cannot be used because NIR is up against the zero bound
