Macroeconomics: Chapter 17

Milton Friedman Arguement

Argued that in the long-run there is no trade-off between unemployment and inflation. He stated that in the long-run only natural rate of unemployment exists.

Phillips Curve

Curve which shows the short-run relationship between the unemployment rate and the inflation rate. When aggregate demand decreases, unemployment usually rises and inflation falls whereas an aggregate demand increases, unemployment usually falls and inflation rises. As a result, there is a short-run trade-off between unemployment and inflation: Higher employment is usually accompanied by lower inflation, and lower unemployment is usually accompanied by the higher inflation

AD-AS Model

When aggregate demand increases, real GDP and price level increases and due to this increase in real GDP and price level, unemployment usually falls and inflation rises. When Aggregate Demand decreases, real GDP and price level also decrease and unemployment usually rises and inflation falls. This model provides the reason for the short-run trade-off between unemployment and inflation.

Adaptive Expectations

When firms and workers have these with regards to inflation and Federal Reserve administraters expansionary policy then in that case upward movement along the short-run Phillips curve takes place and administration of contractionary monetary plicy then in that case downward movement along the short-run Phillips curve takes place.

Expected Inflation Rate

Rate at which firms and households form expectations about the increase in future price level

Magnitude of Growth

Aggregate demand influences the magnitute of inflation and unemployment. Slow growth of aggregate demand results in lower inflation and higher unemployment. Strong growth in ggregate demand results in higher inflation and lower unemployment

Vertical Long-run

Aggregate supply curve implies that even if there is change in aggregate demand there would be no change in equilibrium real GDP as it is at its potential level as indicated by the vertical long-run supply curve. Only price level would increase or decrease in this case. As equilibirum real GDP remains the same there would be no impact on the employment in the economy and thus in the long run, a higher or lower inflation rate will have no effect on the unemployment rate because the unemployment rate is always equal to the natural rate in the long run

Actual Inflation Rate

Rate at which there is sustained increase in the level of current prices in an economy

Structural Relationship

Depends on the basic behavior of consumers and firms and remains unchanged over long periods. This is useful in formulating economic policy because policy makers can anticipate that these relationships are constant or not

Short-run Phillips Curve

Downward sloping curve indicating a trade-off between the inflation and unemployment. This trade-off between unemployment and inflation is possible only if the actual inflation rate differs from the inflation rate that workers and firms have expected

Why did economists during the early 1960s think of the Phillips curve as a 'policy menu'?

Economists during the early 1960s think of the Phillips curve as a "policy menu" because they believed that Phillips curve represents a structural relationship in the economy. They believed that it represents a permanent trade-off between unemployment and inflation. They thought that Phillips curve gives a reliable menu of combinations of unemployment and inflation to the policy makers. Thus, policymakers could use expansionary monetary and fiscal policies to choose a point on the curve that had lower unemployment and higher inflation.

Rational Expectations

Expectations formed by using all available information about an economic variable. While forming the expectation about future inflation rate workers and firms are using all the available information

Potential GDP

Ideal level of GDP. At this level all the resources are fully employed

High Unemployment to Low

If Fed wants to move from a point on the short-run Phillips curve representing high unemployment and low inflation to a point representing lower unemployment, it has to adopt an expansionary monetary policy

If both the short-run and long-run Phillips curves are vertical, what will be the effect on the inflation rate and the unemployment rate of expansionary policy?

If both the short-run and long-run Phillips curves are vertical, then an expansionary policy will have no effect on the unemployment rate but will lead to an increase in inflation

Natural Rate of Unemployment

Rate of unemployment that exists when the economy is at potential GDP

Actual Inflation

If this is lesser than households and firms had previously expected, then the actual real wage will end up being greater than the expected real wage. This is because: Real Wages= Nominal Wages/Prices. Since, the increase in actual prices is less than expected increases in prices. The denominator in the formula would be less than in actual as compared to expected. Resulting in real wages to be higher

Suppose the expected inflation rate increases from 4% to 6%. What will happen to the short-run Phillips curve?

Inflation and unemployment are two important variables. The term inflation will mean continuous rise in price. Unemployment is the percentage of unemployed workable labor force. Rise in inflation will increase profitalbility, new employment opportunities will be created. Unemployment will decrease. This relation is shown by a downward sloping curve.

During a time when the inflation rate is increasing each year for a number of years, are adaptive expectations or rational expectations likely to give the more accurate forecasts

Rational Expectations, adaptive expectations would should that the future inflation rate would always be lower than the actual inflation rate. Rational expectations would be based on all available information that is past as well as current

Non-Accelerating Inflation Rate of Unemployment

Level of unemployment on the Phillips curve for an economy at which there is no inclination for the inflation rate to vary and rate of unemployment stays at its natural rate

Target Policy Rate

Part of a monetary policy. The central bank can set a target interest rate in so as to affect the supply of money in the economy. This in turn would affect the employment and output in the economy

"Prices have gone up the elevator, and wages have had to use the stairs."

Prices are rising much faster than the rise in nominal wages. In this case, real wages would fall

Expansionary Monetary Policy

Results in increase in money supply which will bring down the equilibrium interest rates thus, giving boost to consumption and investment spending. This would increase the aggregate demand, which would increase production and income. Both real GDP and prce level would increase. Rising price level will lead to higher inflation increasing real GDP will result in increasing employment and thus will decrease unemployement rate

Long-run Phillips Curve

Vertical straight line as there is no permanent trade-off between the unemployment and inflation. In the long run, a higher or lower inflation will have no effect on the unemployment rate because the unemployment rate is always equal to the natural rate of unemployment in the long run

Future rate of Inflation

Workers, firms, banks, and investors in financial markets care about the future rate of inflation because future rate of inflation affects the real values that are the values adjusted for inflation. If workers, firms, banks, and investors failed with anticipating the fluctuations in inflation during the future years then they could experience declines in real wages, real profits, interest rates, and real returns from financial markets