Principles of Economics Chapter 35

Expansionary policy

moves up the SRP curve

natural rate hypothesis

the claim that unemployment eventually returns to its normal or natural rate, regardless of the rate of inflation. There is no trade of between inflation and unemployment (see page 795 for U.S historical example)

stagflation

the combination of falling output and rising prices

The Sacrifice Ratio

the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. If a nation wants to reduce inflation, it must induce a period of high unemployment and low output. A typical estimate of the sacrifice ratio is 5. That is, for each percentage point that inflation is reduced, 5 percent of annual output must be sacrificed in the transition

rational expectations

the theory that people optimally use all the information they have including information about the government policies when forecasting the future According to rational expectations theorists, estimates of the sacrifice ratio are unreliable guide for policy. The sacrifice ratio could be much smaller than suggested by previous estimates. The short-run phillips curve would shift downward and the economy would reach low inflation quickly without the cost of temporarily high unemployment and low output.

Vertical long-run phillips curve

the unemployment rate tends toward its normal level called the natural rate of unemployment. The vertical curve illustrates that unemployment does not depend on money growth and inflation in the long-run.

Policy Makers ask whether the shift in SRP curve is temporary or permenant

How do people adjust their expectations of inflation? If people view the rise in inflation de to the supply shock as temporary, aberration, expected inflation will not change, and the phillips curve will soon revert to its former position. But if people believe the shock will lead to a new era of high inflation, then expected inflation will rise, and the phillips curve will will remain at its new less desirable position

The meaning of natural

Natural = frictional + structural. Monetary policy cannot affect it. To reduce the natural rate of unemployment policy-makers should look to policies that improve the functioning of the labor market.

Why should anyone believe that policy makers faced a vertical phillips curve when th world seemed to offer a downward sloping one?

They claimed that the negative relationship between inflation and unemployment exists in the short run, but that it cannot be used by policy makers as a menu of outcomes in the long run. Policy makers can pursue expansionary monetary policy to achieve lower unemployment for a while, but eventually it will return to natural rate and excess leads only to higher inflation.

The Short run philips curve:

Unemployment rate = natural rate of unemployment - a(actual inflation - expected inflation) This equation implies that there can be no stable short-run phillips curve. The downward sloping short-run phillips curve intersects the vertical long-run phillips curve at the expected rate of inflation. When expected inflation changes, the short run philips curve shifts. In the short run, expected inflation is given, so higher actual inflation is associated with lower unemployment. In the long run, people come to expect whatever inflation the Fed produces, so actual inflation equals expected inflation and unemployment is at its natural rate

phillips curve

a curve that shows the the short run trade-off between inflation and unemployment. It 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. Shifts in the aggregate demand push inflation and unemployment in opposite directions in the short run a relationship illustrated by the phillips curve

supply shock

an event that directly alters firms' costs and prices, shifting the economy's aggregate supply curve and thus the Phillips curve. decrease in aggregate supply, shifts the phillips curve to the right. Leading to higher unemployment rate, and higher inflation. Policy

expected inflation

measures how much people expect the overall price level to change. because the affected price level affects nominal wages, expected inflation is one factor that determines the position of the SRAS curve. The fed's ability to create unexpected inflation only by increasing the money supply only exists in the short run. In the long run, people come to expect whatever inflation rate the fed chooses to produce, and nominal wages will adjust to keep pace with inflation. As a result, the LRAS curve is vertical

Phillips curve specifics

sIncreases in the money supply, increases in government spending, or cuts in taxes expand aggregate demand and move the economy to a point on the phillips curve with lower unemployment and higher inflation. Decreases in the money supply cuts in government spending or increases in taxes contract aggregate demand and move the economy to a point on the phillips curve with lower inflation and higher unemployment

Classical Theory points out:

that growth in the money supply as the primary determinant of inflation. Also states that monetary growth does not affect real variables such as output and employment. Monetary growth does not influence those factors that determine the economy's unemployment rate, such as the market power of unions, the role of efficiency wages, or the process of job search. Therefore, Friedman and Phelps concluded that there is no reason to think that the rate of inflation would, in the long run, be related to the rate of unemployment