The Phillips Curve Unemployment vs Inflation Managing the

The Phillips Curve Unemployment vs. Inflation Managing the short run trade-off

Employment & Inflation • Full Employment level depends on each country’s features of labor market: • Including: minimum-wage laws, the market power of unions, the effectiveness of job search (think internet) , & other labor laws etc…. • In USA = 4. 5% • Inflation rate depends on growth in the quantity of money • Supply of money is controlled by the Federal Reserve

Fiscal Policy: short run trade off • If policymakers ↑ aggregate demand, they can lower unemployment, but only at the cost of higher inflation • If they ↓ aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment

Short Run Phillips Curve % Inflation Rate B 6 A 2 0 4 7 Short Run Phillips curve % Unemployment Rate

Phillips Curve & SRAS Curve Aggregate Demand & Aggregate Supply Price Level Inflation Rate (percent per year) SRAS 6 B 106 102 The Phillips Curve B A AD 2 AD 1 0 7, 500 8, 000 (unemployment is 7%) is 4%) Phillips curve Real GDP or Output 0 4 (output is 8, 000) Unemployment 7 (output is Rate (percent) 7, 500) If SRAS shifts => Short Run Phillips Curve shifts (but in opposite direction)

The Long-Run Phillips Curve • In the 1960 s, Friedman & Phelps concluded that inflation & unemployment are unrelated in long run – As a result, the long-run Phillips curve is vertical at full employment Milton Friedman

The Long-Run Phillips Curve Inflation Rate 1. When the Fed increases Money supply The rate of inflation rises High inflation Low inflation 0 Long-run Phillips curve B A Natural rate of unemployment 2. . but unemployment remains at its natural rate in the long run. Unemployment Rate

Phillips Curve & Long Run AS The Phillips Curve Aggregate Demand Aggregate Supply Model Price Level P 2 2. . raises the price P level. . . Inflation Rate LRAS B Long-run Phillips curve 3. . and increases the inflation rate. . . 1. An decrease in Taxes increases Aggregate demand. . B A A AD 2 AD 1 0 Natural rate of output Quantity of Output 0 4. . but leaves output and unemployment at their natural rates. Natural rate of unemployment Unemployment Rate

Conclusion • In long run, expected inflation adjusts to changes in actual inflation – So fiscal policy is not effective in lowering unemployment only in increasing inflation • Fed can only create unexpected inflation in short run – Once people anticipate inflation, they adjust. – Only way to get unemployment below the natural rate is for actual inflation to be above anticipated

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