The Phillips Curve Unemployment vs Inflation Managing the

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

Full Employment & Inflation • Full Employment rate depends on features of a labor market: minimum-wage laws, market power of unions, effectiveness of job search (think internet) , & other labor laws etc…. • In USA = 4. 0% In France = 8. 0% • Including: • Inflation rate depends on growth in the quantity of money • Supply of money is controlled by the Federal Reserve – creates demand-pull inflation

Short Run Trade Off: Fiscal Policy • Expansionary => ↑ AD => unemployment falls but inflation ↑ • Contractionary =>↓ AD => inflation falls but unemployment ↑ LRAS 1 Price Level -------- P 1 ------------- P 2 SRAS 1 1) There is a short run trade off between: inflation & unemployment E 2 E 1 AD 2 AD 1 Y 2 AS/AD Model Conclusion Real GDP 2) There is no long run relationship….

Short Run Phillips Curve (SRPC) % Inflation Rate 6 You can lower unemployment by creating ↑ inflation (in short run) B A 2 0 SRPC 3% 4% % Unemployment Rate

SRAS & SRPC 1) If AD ↑ => Move upward SRAS => move upward SRPC 2) If SRAS shifts => SRPC shifts in the opposite direction AS/AD Model Price Level LRAS Inflation Rate SRAS 6% B 106 102 Short Run Phillips Curve B A AD 2 A 2% AD 1 0 7, 500 8, 000 (full unemployment (unemployment is 4%) is 3%) SRPC Real GDP or Output 0 3% (R-GDP is 8, 000) Unemployment 4% (R-GDP is Rate 7, 500)

The Long-Run Phillips Curve • In the 1960 s, Friedman & Phelps concluded that inflation & unemployment are unrelated in long run Inflation is only related to the Quantity Of Money Federal Reserve controls money supply Therefore, the Long-Run Phillips curve is vertical at full employment level

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

Graphing Phillips Curves • Phillips Curves are drawn on one graph – If AS/AD is @ full potential => Phillips curves @ full employment – Point A on both graphs • Inflationary or Recessionary Gaps will follow AS/AD shifts AS/AD Model Price Level LRAS infla Inflation Rate SRAS 6% B 106 102 B= Phillips Curve Model tiona ry g a p LRPC B A AD 2 A 2% AD 1 0 7, 500 8, 000 (full unemployment (unemployment is 4%) is 3%) SRPC Real GDP or Output 0 3% (R-GDP is 8, 000) Unemployment 4% (R-GDP is Rate 7, 500)

Phillips Curve Summary • Short Run => inflation increases both R-GDP & employment • Long Run => inflation does not impact R-GDP or employment • Conclusion: Fiscal Policy not helpful in the long run! (should focus on shifting PPF!)

Worksheet