Phillips Curve and Monetary Policy

Aggregate Demand and Supply

Greater output implies more investment.
Unemployment and output are inversely related. They are two sides of the same coin.
Higher price level in the current year leads to higher inflation.

Aggregate Demand (AD): Composed of consumption, investment, government spending, and net exports.
Phillips Curve: Shows the relationship between the inflation rate and the unemployment rate.
Short Run Aggregate Supply (SRAS): An upward-sloping curve.

Policymakers can choose a point on the Phillips curve to operate.
The Federal Reserve (The Fed) has conflicting objectives: managing unemployment and inflation.
To reduce unemployment (e.g., from 10% to 4%), the Fed can increase the money supply.
- This lowers interest rates, encouraging investment and increasing AD.
- Output increases, unemployment decreases, but the price level and inflation rise.

Monetary Policy: Managed by the Federal Reserve.
Fiscal Policy: Capital investment (e.g., Biden administration) or reduction in government spending (e.g., Trump administration).
Both monetary and fiscal policies shift the AD curve.
To contract output, AD reduces due to pessimism, increased interest rates, or reduced government spending.
- This shifts the AD curve to the left, lowering output and increasing unemployment.
- Price levels decrease.

In the long run, shifts in AD do not have lasting effects on output.
Starting at equilibrium where AD = SRAS = Long Run Aggregate Supply (LRAS) at potential output:
- Increasing the money supply or fiscal spending shifts AD to the right.
This new equilibrium is not stable because price level expectations adjust.
As expectations change, the SRAS shifts upwards until a new long-run equilibrium is established.
The new long-run equilibrium occurs where the new SRAS equals AD and LRAS.
Output returns to potential, and the expected price level equals the actual price level.

Monetary growth has no real impact on the economy in the long run.
This is called monetary neutrality, where money cannot affect factors determining the economy's potential output.
Inflation is a monetary phenomenon.
In the long run, there is no real relationship between unemployment and inflation.
The Phillips curve is vertical at the natural rate of unemployment, equivalent to potential output.

The Federal Reserve influences unemployment and inflation through monetary policy.
The actual unemployment rate is related to the natural rate of unemployment by:
\text{Unemployment Rate} = \text{Natural Rate of Unemployment} - \text{Constant} \times (\text{Actual Inflation} - \text{Expected Inflation})
Where constant is typically 1.
If actual inflation is greater than expected inflation:
- Consumption reduces because prices are high.
- Output reduces, increasing unemployment.
- The term (\text{Actual Inflation} - \text{Expected Inflation}) is positive, making the overall reduction from the natural rate negative.
Changes in expected inflation shift the short-run Phillips curve.

Starting at point A, expansionary monetary or fiscal policy shifts AD to the right, moving the economy to point B.
Inflation increases.
Over time, people adjust to the new level of inflation, raising their expectations.
This leads to a shift in the short-run Phillips curve to the right.
Example:
- Initial state: Actual inflation = 4%, Expected inflation = 4%, Unemployment rate = Natural rate.
- Expansionary policy moves the economy to where Actual inflation = 6%, Expected inflation = 4%.
- This reduces the actual unemployment rate below the natural rate.
- Eventually, expectations adjust to 6%, shifting the Phillips curve to the right, and unemployment returns to the natural rate at a higher inflation rate.

If AD shifts to the left due to reduced money supply or pessimism:
- The price level falls, but unemployment increases.
- Expected inflation is greater than actual inflation.
- The unemployment rate becomes the natural rate plus an additional term, increasing it above the natural rate.
- Eventually, expectations update, shifting the Phillips curve to the left.
To bring prices down, unemployment must be driven higher.
This trade-off is called the sacrifice ratio: how much unemployment must increase to reduce inflation.

Policymakers can aim for a point on the Phillips curve using expansionary or contractionary policies.
However, the curve shifts as expectations change.
If the goal is to lower inflation, it often requires driving unemployment higher, and vice versa.
Being the chair of the Fed involves managing these trade-offs.