Inflation and Unemployment

The Long-Run Phillips Curve

According to Friedman and Phelps, there is no trade-off between High inflation and unemployment in inflation the long run; When the Fed increases the growth rate of the money supply, the rate of inflation increases, but unemployment remains at its natural rate in the long run. Thus, the vertical long-run aggregate-supply curve and the vertical long-run Phillips curve both imply that monetary policy influences nominal variables (the price level and the inflation rate) but not real variables (output and unemployment). 1) An increase in the money supply increases aggregate demand, 2) raises the price level, 3) and increases the inflation rate, 4) but leaves output and unemployment at their natural rates.

The Volcker Disinflation

Cost of reducing inflation; reducing the level of inflation requires a sharp reduction in the rate for money growth- a tight monetary policy.

The Sacrifice Ratio

Cost of reducing inflation; the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point

Rational Expectations and the Possibility of Costless Disinflation

Cost of reducing inflation; the theory that people optimally use all the information they have, including information about government policies, when forecasting the future

Philips curve

Illustrates a negative association between the inflation rate and the unemployment rate because low unemployment is associated with high aggregate demand that puts upward pressure on wages and prices throughout the economy.

Expected inflation

Shift in the philips curve; Measures how much people expect the overall price level to change; Because the expected price level affects nominal wages, expected inflation is one factor that determines the position of the short-run aggregate-supply curve; The Fed's ability to create unexpected inflation by increasing the money sup- ply exists only in the short run. In the long run, people come to expect what- ever inflation rate the Fed chooses to produce, and nominal wages will adjust to keep pace with inflation

The Role of Supply Shocks

Shift in the philips curve; an event that directly alters firms' costs and prices, shifting the economy's aggregate- supply curve and thus the Phillips curve

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The Phillips curve 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. An increase in the aggregate demand for goods and services leads, in the short run, to a larger output of goods and services and a higher price level: the larger output lowers unemployment, but the higher prices is inflation. Increases 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.

Reconciling Theory and Evidence

They claimed that a negative relationship between inflation and unemployment exists in the short run but that it cannot be used by policymakers as a menu of out- comes in the long run. Policymakers can pursue expansionary monetary policy to achieve lower unemployment for a while, but eventually, unemployment returns to its natural rate, and more expansionary monetary policy leads only to higher inflation.

The Short-Run Phillips Curve

Unemployment rate= natural rate of unemployment - a (actual inflation - expected inflation) This equation implies there can be no stable short-run Phillips curve as each short-run Phillips curve reflects a particular expected rate of inflation. When expected inflation changes, the short-run Phillips curve shifts. 1) Expansionary policy moves the economy up along the short-run Phillips curve, 2) but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right.

The Natural Experiment for the Natural-Rate Hypothesis

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