Chapter 22 - The Short-Run Trade-Off Between Inflation and Unemployment

22.2: The Phillips Curve

Origins of the Phillips Curve:

• Phillips curve- a curve that shows the short-run trade-off between inflation and unemployment

  

Aggregate Demand, Aggregate Supply, and the Phillips Curve:

• Shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate supply curve.

• Decreases in the money supply, cuts in government spending, or increases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment.

  

Shifts in the Phillips Curve: The Role of Expectations:

• Shifts in the Phillips Curve: The Role of Expectations

22.2: Shifts in the Phillips Curve: The Role of Expectations

The Long-Run Phillips Curve:

• Natural rate of unemployment levels Unemployment does not depend on money growth and inflation in the long run.

  

  

The Meaning of “Natural”:

• The “natural” rate of unemployment
  • Is used to describe the unemployment rate toward which the economy gravitates in the long run.
• Lower unemployment means more workers are producing goods and services, the quantity of goods and services supplied would be larger at any given price level, and the long-run aggregate supply curve would shift to the right.

Reconciling Theory and Evidence:

• Changes in aggregate demand, such as those due to changes in the money supply, affect neither the economy’s output of goods and services nor the number of workers that firms need to hire to produce those goods and services.

The Short-Run Phillips Curve:

• Unemployment rate = Natural rate of unemployment - a(actual inflation-expected inflation)The variable a is a parameter that measures how much unemployment responded to unexpected inflation

  

The Natural Experiment for the Natural-Rate Hypothesis:

• Natural-rate hypothesis- the claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation

  

  

22.3: Shifts in the Phillips Curve: The Role of Supply Shocks

• Supply shock- an event that directly alters firms’ costs and prices, shifting the economy’s aggregate supply curve and thus the Phillips curve

  

  

22.4: The Cost of Reducing Inflation

The Sacrifice Ratio:

• Sacrifice Ratio- the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point

  

Rational Expectations and the Possibility of Costless Disinflation:

• Rational expectations- the theory that people optimally use all the information they have, including information about government policies, when forecasting the future
• The economy would reach low inflation quickly without the cost of temporarily high unemployment and low output

The Volcker Disinflation:

• Does not necessarily refute the rational-expectations view that credible disinflation can be costless.

  • It shows that policymakers cannot count on people immediately believing them when they announce a policy of disinflation

  

The Greenspan Era:

• During this period, Alan Greenspan was chairman of the Federal Reserve

  • Fluctuations in inflations and unemployment were small
  • This period was a favorable supply shock

  

The Phillips Curve during the Financial Crisis:

• Financial crisis caused by aggregate demand to plummet

  • It led to a higher unemployment rate
  • Pushed down inflation to a very low level