Institute of International Education 4 3 The short run trade off between Inflation and Unemployment ▪ How are inflation and unemployment related in the short run? In the long run? ▪ What factors alter[.]
The short-run trade-off between 4.3 Inflation and Unemployment ▪ How are inflation and unemployment related in the short run? In the long run? ▪ What factors alter this relationship? ▪ What is the short-run cost of reducing inflation? Institute of International Education Introduction ▪ In the long run, inflation & unemployment are unrelated: ▪ The inflation rate depends mainly on growth in MS, controlled by Fed ▪ The natural rate of unemployment depends on the minimum wage, the market power of unions, efficiency wages, and process of job search Institute of International Education Unemployment and Inflation ▪ One of the Ten Principles: In the short run, society faces a trade-off between inflation and unemployment ▪ If policymakers expand AD, they can lower unemployment, but only at the cost of higher inflation ▪ If they contract AD, they can lower inflation, but at the cost of temporarily higher unemployment Institute of International Education The Phillips Curve The Phillips curve illustrates the short-run relationship between inflation and unemployment ▪ The greater the AD for goods and services, the greater is the economy’s output, and the higher is the overall price level ▪ A higher level of output results in a lower level of unemployment Institute of International Education AD, AS & the Phillips Curve (b) The Phillips Curve (a) The Model of AD and AS Price Level SRAS 106 B 102 A Inflation Rate (% per year) High AD Low AD 7,500 (unemployment is 7%) Institute of International Education Y 8,000 (unemployment is 7%) B A Phillips curve Unemployment (output is (output is Rate (%) 8,000) 7,500) Shifts in the Phillips Curve ▪ The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes • low unemployment with high inflation • low inflation with high unemployment • anything in between Institute of International Education The Vertical Long-Run Phillips Curve ▪ 1968: Economists argued that the tradeoff was temporary ▪ Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or “natural” rate, regardless of the inflation rate ▪ As a result, the long-run Phillips curve is vertical at the natural rate of unemployment Institute of International Education ... wages, and process of job search Institute of International Education Unemployment and Inflation ▪ One of the Ten Principles: In the short run, society faces a trade- off between inflation and unemployment. .. Education The Phillips Curve The Phillips curve illustrates the short- run relationship between inflation and unemployment ▪ The greater the AD for goods and services, the greater is the economy’s... policymakers expand AD, they can lower unemployment, but only at the cost of higher inflation ▪ If they contract AD, they can lower inflation, but at the cost of temporarily higher unemployment