Demonstrates the short-run tradeoff between inflation and unemployment
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Demonstrates the short-run tradeoff between inflation and unemployment. The Phillips Curve. Annual Rate of Inflation (Percent). Annual Rate of Inflation (Percent). Unemployment Rate (Percent). Unemployment Rate (Percent). The Phillips Curve. Concept. Empirical Data Data for the 1960s. 69.

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Unemployment Rate (Percent)

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Unemployment rate percent

Demonstrates the short-run tradeoff between inflation and unemployment

The Phillips Curve

Annual Rate of Inflation (Percent)

Annual Rate of Inflation (Percent)

Unemployment Rate (Percent)

Unemployment Rate (Percent)

The Phillips Curve

Concept

Empirical Data

Data for the 1960s

69

68

66

67

65

63

62

61

64

35-1

LO3


Unemployment rate percent

The Phillips Curve

  • In the short-run, this is correct.

  • Typical short-run Phillips curve (SRPC) looks like this:

OR THIS

Inflation %

Inflation %

SRPC

SRPC

Unemployment %

Unemployment %


Unemployment rate percent

What Questions Can We Answer Already?

  • Which of the following is depicted in the graph below?

Aggregate demand curve

Long-run Phillips curve

Short-run Phillips curve

Long-run aggregate supply curve

Short-run aggregate supply curve.

Inflation %

Unemployment %


Unemployment rate percent

What Questions Can We Answer Already?

  • According to the short-run Phillips curve, lower inflation rates are associated with…

Inflation %

SRPC

Unemployment %


Unemployment rate percent

What Questions Can We Answer Already?

  • A short-run Phillips curve shows an inverse relationship between…

Inflation %

SRPC

Unemployment %


Unemployment rate percent

What Questions Can We Answer Already?

  • According to the short-run Phillips curve, a decrease in unemployment is expected to be accompanied by…

Inflation %

SRPC

Unemployment %


Unemployment rate percent

What Questions Can We Answer Already?

  • According to the short-run Phillips curve, there is a trade off between…

Inflation %

SRPC

Unemployment %


Unemployment rate percent

LRAS

SRAS

PL1

Price Level

PL2

AD

AD2

Y1

Y2

  • Real GDP


Unemployment rate percent

LRAS

SRAS

PL2

Price Level

PL1

AD2

AD

Y1

Y2

  • Real GDP


Unemployment rate percent

Draw a correctly labeled Phillips curve showing the actual unemployment and inflation rates for both years. Label this curve SRPC.

Inflation %

8

SRPC

4

Unemployment %

2

5


Unemployment rate percent

Assume the United States economy is operating at full-employment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recession.

Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in consumption spending. Label the initial position “A” and the new position “B”.

A

Inflation %

B

SRPC

Unemployment %


Unemployment rate percent

Assume that a country’s government increases domestic military expenditures.

Using a correctly labeled graph of the short-run Phillips curve, show the effect of the increased military expenditures in the short run, labeling the initial point as A and the new point as B.


Unemployment rate percent

Assume that a country’s government decreases personal income taxes.

(a) Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decreased personal income taxes in the short run, labeling the initial point as A and the new point as B. (This one’s not on the handout.)


Unemployment rate percent

In the long run, however, as we learned yesterday, the unemployment rate will always return to natural rate of unemployment, or full employment. So the long-run Phillips curve looks like this:

LRPC

Inflation %

SRPC

The natural rate of unemployment is consistent with ANY RATE OF INFLATION in the LONG RUN!!!

Unemployment %


Unemployment rate percent

So what can we say about the Long-run Phillips Curve?

LRPC

Inflation %

  • It shows no trade-off between inflation and unemployment.

  • It is vertical at the natural rate of unemployment.

SRPC

Unemployment %


Unemployment rate percent

How could we show an economy in long-run equilibrium with a graph of both the long-run and short-run Phillips curves?

LRPC

A

Inflation %

SRPC

Unemployment %


Unemployment rate percent

An economy is in short-run equilibrium at an output level above full employment. Demonstrate this using both a short-run and long-run Phillips curve. Label the equilibrium point A.

LRPC

A

Inflation %

SRPC

Unemployment %


Unemployment rate percent

An economy is in short-run equilibrium at an output level below full employment. Demonstrate this using both a short-run and long-run Phillips curve. Label the equilibrium point A.

LRPC

Inflation %

A

SRPC

Unemployment %


Unemployment rate percent

Changes in the inflation rate, in the long run, will shift the SRPC so that the new inflation rate lies on the Long-run Phillips Curve.

If inflation is lower, the SRPC will shift to the left.

LRPC

A

Inflation %

B

SRPC

SRPC2

Unemployment %


Unemployment rate percent

Changes in the inflation rate, in the long run, will shift the SRPC so that the new inflation rate now lies on the Long-run Phillips Curve.

If inflation is higher, the SRPC will shift to the right.

It turns out that inflationary expectations are just as important in shifting the SRPC. If workers and businesses expect inflation, they will build it into wages, which will actually cause inflation.

LRPC

B

A

Inflation %

SRPC2

SRPC

Unemployment %


Unemployment rate percent

An economy is in short-run equilibrium at an output level below full employment. Demonstrate this using both a short-run and long-run Phillips curve. Label the equilibrium point A.

LRPC

Inflation %

A

SRPC

Unemployment %


Unemployment rate percent

Assume now that this economy is allowed to return to long-run equilibrium without government intervention. Demonstrate the effect of this on your graph.

LRPC

Inflation %

A

B

SRPC

SRPC2

Unemployment %


Unemployment rate percent

Assume that the economy is in long-run equilibrium.

Draw a correctly labeled graph of the short-run and long-run Phillips curves. Label the long-run equilibrium point A.

Assume that consumer confidence falls. What affect will this drop in consumer confidence have on output and price level in the short run?

Add a new point (B) to your Phillips curve that shows the short-run effect of this drop in consumer confidence.

What effect will this have on the SRPC in the long run?

LRPC

A

Inflation %

B

SRPC

SRPC2

Unemployment %


Unemployment rate percent

How do changes in the inflation rate or changes in inflationary expectations change the Long-run Phillip’s curve?

They Don’t!

LRPC

Inflation %

SRPC

Unemployment %


Unemployment rate percent

Could anything shift the long-run Phillips curve?

Yes!

What?

A change in the natural rate of unemployment.

LRPC

Inflation %

Unemployment %


Unemployment rate percent

Assume that on-line job searches reduce the rate of frictional unemployment. Demonstrate this using a long-run Phillips curve.

LRPC2

LRPC

Only a change in the natural rate of unemployment, or the full employment level, will shift the LRPC. Changes in aggregate demand, price level, actual unemployment rate, none of these will move it!

Inflation %

Unemployment %


Unemployment rate percent

True or False: According to the long-run Phillips curve,

The natural rate of unemployment is independent of monetary and fiscal policy changes that affect aggregate demand.

LRPC

Inflation %

Unemployment %


Unemployment rate percent

Inflation and expected inflation are important determinants of economic activity.

(a) Draw a correctly labeled graph of a short-run Phillips curve.

Inflation %

SRPC

Unemployment %


Unemployment rate percent

Inflation and expected inflation are important determinants of economic activity.

(b) Using your graph in part (a), show the effect of an increase in the expected rate of inflation.

LRPC

Inflation %

SRPC2

SRPC

Unemployment %


Unemployment rate percent

Inflation and expected inflation are important determinants of economic activity.

(c) What is the effect of the increase in the expected rate of inflation on the long-run Phillips curve?

  • There is no effect on the long-run Phillips curve.

    The only thing that affects the long-run Phillips curve is a change in the natural rate of unemployment!


Unemployment rate percent

(d) Given the increase in the expected rate of inflation from part (b),

  • will the nominal interest rate on new loans increase, decrease, or remain unchanged?

    It will increase.

    (ii) will the real interest rate on new loans increase, decrease, or remain unchanged?

    It will not change.


Unemployment rate percent

(e) Assume that the nominal interest rate is 8 percent. Borrowers and lenders expect the rate of inflation to be 3 percent, and the growth rate of real gross domestic product is 4 percent. Calculate the real interest rate.

  • The real interest rate is 5%.


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