Chapter 22: The Short Run Trade Off Between Inflation and Unemployment

Supply Shock

An event that directly alters firms' costs and prices, shifting the economy's aggregate-supply curve and thus the Phillips curve.

Phillips Curve

A curve that shows the short run trade off between inflation and unemployment. A curve that shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve.

What is the difference between the short-run and long-run Phillips curve?

The long-run Phillips curve is negatively sloped, indicating an inverse relationship between unemployment and inflation, whereas the short-run curve is vertical.

Misery Index

The sum of the unemployment and inflation rates.

Long Run Phillips Curve

According to Friedman and Phelps, there is no trade-off between inflation and unemployment in the long run. Growth in the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical.

Natural Rate Hypothesis

The claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation.

Sacrifice Ratio

The number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point.

Rational Expectations

The theory that people optimally use all the information they have, including information about government policies, when forecasting the future.