Chapter 16 - Shortrun tradeoff between inflation and unemployment

The Phillips Curve: Summary

When the aggregate demand changes, the economy will move along the Phillips curve. An increase in AD will move the economy to a point on the Phillips curve with higher inflation and lower unemployment. A decrease in AD will move the economy to a point on the Phillips curve with lower inflation and higher unemployment.

The Phillips curve

a curve that shows the short run trade-off between inflation and unemployment

Rational expectations

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

Misery Index equation

= Unemployment Rate + Inflation Rate high unemployment and high inflation from arthur okun in 1970

In the long run, the Phillips curve is vertical.

AD in the long run has no effect on output, only price because of LRAS The long run Phillips curve occurs at the natural rate of unemployment.

adverse vs. favourable supply shock

Adverse supply shock (for example, oil crisis) leads to higher inflation and higher unemployment. Favourable supply shock (for example, technological progress) leads to lower inflation and lower unemployment.

The Natural-Rate Hypothesis policy implications

In the short run, policymakers can trade off inflation and unemployment by controlling the aggregate demand. There is no trade-off between inflation and unemployment in the long run. The unemployment is always equal to its natural rate in the long run regardless of the rate of inflation.

SRPC and LRPC

SRPC => u = ubar - b(pi -pi*e*) LRPC => u = ubar

Supply Shocks

is an event that directly affects firms' costs of production and thus the prices they charge, shifting the AS and the Phillips curve. Supply shock could be adverse or favourable. Adverse supply shock (for example, oil crisis) leads to higher inflation and higher unemployment. Favourable supply shock (for example, technological progress) leads to lower inflation and lower unemployment.

The Natural-Rate Hypothesis

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

Sacrifice ratio

the number of percentage points of one year's output lost in the process of reducing inflation by one percentage point. to estimate: you need to know 1. how change in inflation affects unemployment 2. how change unemployment affects output

Okun's law

the number of percentage points the output falls when the unemployment rate increases by one percentage point.

short run philips curve

u = ubar - b(pi -pi*e*) actual unemployment = natural unemployment -how much unemployment responds to inflation (actual inflation - expected inflation)