Chapter 15: The Short-Run Policy Tradeoff

Expected Inflation

The inflation rate that people forecast and use to set the money wage rate and other money prices. Because the actual inflation rate equals the expected inflation rate at full employment, we can interpret the Long-Run Phillips Curve as the relationship between inflation and unemployment when the inflation rate equals the expected inflation rate.

What is the correlation between Unemployment and Real GDP?

--Unemployment = x-axis on SRPC --Real GDP = x-axis on AS curve Potential GDP: (real GDP when all factors of production are employed) Full employment: (natural unemployment rate = unemployment rate) 1--At full employment the quantity of real GDP is potential GDP and the unemployment rate is the natural unemployment rate. 2--If real GDP exceeds potential GDP, employment exceeds its full employment level and the unemployment rate falls below the natural unemployment rate. 3--If real GDP falls below potential GDP, employment is less than its full employment level and the unemployment rate rise above the natural unemployment rate.

What happens when the unemployment rate is Low and High in the Short Run Phillips Curve?

1--A lower unemployment rate brings a higher inflation rate 2--A higher unemployment rate brings a lower inflation rate

What is the relationship between the Aggregate Supply/Demand Curve with the Short Run Phillips Curve?

1--When the Aggregate Demand shifts there is movement along the Short Run Phillips Curve. 2--When the Aggregate Supply curve shifts there is a shift in the Short Run Phillips Curve.

Short-Run Phillips Curve

A curve that shows the relationship between the inflation rate and the unemployment rate when the natural unemployment rate and expected inflation rate remain constant.

Long Run Phillips Curve

A vertical line that shows the relationship between inflation and unemployment when the economy is at full employment.

What happens along the Supply Curve?

Along the Aggregate Supply Curve, the money wage rate is fixed. So when the price level rises, the real wage rate falls. And the quantity of labor employed increases. Along the Short-Run Phillips Curve, the rise in the price level means an increase in inflation. The increase in quantity of labor employed means a decrease in the number unemployed and a decrease in the unemployment rate.

Why is there no Long-Run Trade-off?

Because the long run Phillips curve is vertical, there is no long-run trade-off between unemployment and inflation. In the long-run, the unemployment rate is the natural unemployment rate, BUT any inflation rate can occur.

Okun's Law

For each percentage point that the unemployment rate is above the natural unemployment rate, real GDP is 2 percent below potential GDP.

Lowering the Inflation Rate

If the Fed wants to lower the inflation rate, it can pursue two alternative lines of attack. 1--A surprise inflation reduction **The inflation rate falls and the unemployment rate increases as the economy slides down along the short run Phillips Curve. Gradually, the expected inflation rate falls and the short-run Phillips curve gradually shifts downward. 2--A credible announced inflation reduction (This credible announced inflation reduction lowers the inflation rate but with no accompanying loss of output or increase in unemployment) **A credible announced plan to reduce the inflation rate lowers the expected inflation rate and shifts the short-run Phillips curve downward.

Changes in the Natural Unemployment Rate

If the natural unemployment changes, both the long-run Phillips curve and the short-run Phillips curve shift. When the natural unemployment rate increases, both the long-run Phillips curve and the short-run Phillips curve shift rightward. When the natural unemployment rate decreases, both the long-run Phillips curve and the short-run Phillips curve shifts leftward.

What is the movement along the Aggregate Supply Curve equivalent to?

Short-Run Phillips Curve

Lowering the Unemployment Rate

Suppose that the Fed wants to lower the unemployment rate. The Fed speeds up the growth rate of aggregate demand by speeding up the growth rate of money and lowering the interest rate. With a given expected inflation rate, the unemployment rate initially falls and the inflation rate rises slightly. BUT if the Fed drives the unemployment rate below the Natural Rate, the inflation will continue to rise. As the higher inflation rate becomes expected, wages and prices start to rise more rapidly. If the Fed keeps increasing aggregate demand, the expected inflation rate rises. Eventually, both inflation and unemployment will increase and the economy will return to full employment and the natural unemployment rate. (From Right to Left and back up to Right)

What is another way at looking at the Short Run Phillips Curve?

The Short Run Phillips Curve is another way of looking at the upward-sloping aggregate supply curve. -Both curves arise because the money wage rate is fixed in the short run.

What does the Aggregate Demand Fluctuations bring?

The aggregate demand fluctuations brings movements along the aggregate supply curve and equivalent movements along the Short-Run Phillips Curve.

When does the Aggregate Supply Curve shift?

The aggregate supply curve shifts whenever the money wage rate or potential GDP changes. But the Short-Run Phillips Curve does not shift unless either the natural unemployment or the expected inflation rate change.

Rational Expectation

The forecast that results from the use of all the relevant data and economic science.

Where is the Long Run Phillips Curve vertical line at?

The long-run Phillips Curve is vertical at the natural unemployment rate. In the long-run there is no unemployment -- inflation trade-off.

Inflation Rate

The percentage change in the price level.

Natural Rate Hypothesis

The proposition that when inflation rate changes, the unemployment rate changes temporarily and eventually returns to the natural unemployment rate.