Inflation and Unemployment - The Phillips Curve - Section 6, Module 34

relationship btwn unemployment rate and output gap:

• when actual aggregate output = potential output, actual unemp rate = nat rate of unempl

• when output gap is (+), unemployment is below natural rate and vice cersa for negative output gap

trade off btwn unemployment and inflation

• lower unemployment = higher inflation and vv

  • shown in Phillips curve

Short Run Phillips Curve - represents the negative SR relationship btwn unemployment rate and inflation rate

okun’s law - a rise of 1% in output gap causes a decr in 0.5% in unemployment rate

• incr in AD leads to a decr in the unemployment rate and incr in inflation, so upward movement along SRPC → vv for decr in AD

• negative supply shock shifts SRPC up (inflation rate incr for every level of the unemployment rate) and vv for positive supply shock

  • expected inflation rate - the rate of inflation that employeers/wrokers expect → most important in affecting inflation

expected inflation rate shifts SRPC:

• if inflation is expected to rise in the future, wokresr r going to expect higher wages and employers will be more willing to agree bc hiring will be even more expensive in the future → shifts SRPC up bc actual rate of inflation at any given unemployment point is higher when the expected inflation is higher

in the long run, there is no tradeoff btwn inflation and unemployment

• if u keep trying over and over again to trade off lower unemploument for hgiher inflation, the inflation accelerates over time

• to aboid accel inflation over time, unemploy rate must be high engouh that the actual rate of inflation matches the expected rate of inflation

  • this relationshinp is called natural rate hypotehesis

• NAIRU (nonaccelerating inflation rate of unemployment) - the unemploy rate at which inflation does not change over time

• Long Run Phillips Curve (LRPC) - shows the relationship btwn unempl and inflation in the long run after expectations of inflation have had time to adjust to experience

  • vertical - any unemployment rarte belo NAIRU leads to ever accelerating inflation

NAIRU = natural rate of unempl

disinflation - process of bringing down inflation that has become embdedd in expectations → thru contractionary policies that keep the unempl rate above natural rate for a WHILE

• very costly = short term losses aren’t recoverd, but atl ur not losting more!

deflation - falling aggregate price level

falling PL = dollar in the future has a higher real value than a dollar today, so lenders (who are owed money) gain bc the real value of the borrower’s payments incr, but borrowers lose → opposite of inflation

• deflation can worsen economic slump → takes real resources awat from borrowers and redistributes it to lenders - borrowers are alr short of cash and will be forved to cut spending sharply, but lenders are less likely to increase spening bc the values of their own will rise

  • reduces AD, deepening econ slump, etc

• affects nominal ir

  • zero bound - nom IR cannot go below 0

    • limits the effectiveness of monetary policy: if econ is depressed (unempl > natural unempl and output < potential output), the central bank cant j cut ir to incr AD like it does if nom ir is alr 0

  • liquidity trap - when convential monetary policy can’t be used to fight a slump bc nom ir are up against the 0 bound → can happen when there is a sharp decr in D for loanable funds