The ShortRun Trade Off between Inflation and Unemployment

The Short-Run Trade -Off between Inflation and Unemployment Copyright © 2006 Thomson Learning 35

Figure 1 The Phillips Curve Inflation Rate (percent per year) B 6 A 2 Phillips curve 0 4 7 Unemployment Rate (percent) Copyright © 2004 South-Western

Figure 2 How the Phillips Curve is Related to Aggregate Demand Aggregate Supply (a) The Model of Aggregate Demand Aggregate Supply Price Level 102 Inflation Rate (percent per year) Short-run aggregate supply 6 B 106 B A High aggregate demand Low aggregate demand 0 (b) The Phillips Curve 7, 500 8, 000 (unemployment is 7%) is 4%) Quantity of Output A 2 Phillips curve 0 4 (output is 8, 000) Unemployment 7 (output is Rate (percent) 7, 500) Copyright © 2004 South-Western

Figure 3 The Long-Run Phillips Curve Inflation Rate 1. When the High central bank inflation increases the growth rate of the money supply, the rate of inflation increases. . . 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 Copyright © 2004 South-Western

Figure 4 How the Phillips Curve is Related to Aggregate Demand Aggregate Supply (a) The Model of Aggregate Demand Aggregate Supply Price Level P 2 2. . raises the price P level. . . Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand. . . (b) The Phillips Curve Inflation Rate Long-run Phillips curve 3. . and increases the inflation rate. . . B A A AD 2 Aggregate demand, AD 0 Natural rate of output Quantity of Output 0 Natural rate of unemployment Unemployment Rate 4. . but leaves output and unemployment at their natural rates. Copyright © 2004 South-Western

Figure 5 How Expected Inflation Shifts the Short. Run Phillips Curve Inflation Rate 2. . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Long-run Phillips curve C B Short-run Phillips curve with high expected inflation A 1. Expansionary policy moves the economy up along the short-run Phillips curve. . . 0 Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment Rate Copyright © 2004 South-Western

Figure 6 The Breakdown of the Phillips Curve Copyright © 2004 South-Western

Figure 7 An Adverse Shock to Aggregate Supply (a) The Model of Aggregate Demand Aggregate Supply Price Level 3. . and raises the price level. . . AS 2 P 2 B A P Aggregate supply, AS (b) The Phillips Curve Inflation Rate 1. An adverse shift in aggregate supply. . . 4. . giving policymakers a less favourable trade-off between unemployment and inflation. B A PC 2 Aggregate demand 0 Y 2. . lowers output. . . Quantity of Output Phillips curve, P C 0 Unemployment Rate Copyright © 2004 South-Western

Figure 8 The Supply Shocks of the 1970 s Copyright © 2004 South-Western

Figure 9 Disinflationary Monetary Policy in the Short Run and the Long Run Inflation Rate Long-run Phillips curve 1. Contractionary policy moves the economy down along the short-run Phillips curve. . . A Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation 0 Natural rate of unemployment Unemployment 2. . but in the long run, expected Rate inflation falls, and the short-run Phillips curve shifts to the left. Copyright © 2004 South-Western

Figure 10 The Thatcher Disinflation Copyright © 2004 South-Western