Phillips Curve

Differences between the US Fed and ECB (European Fed)

US = dual mandate, they make policy based on inflation and unemployment Europe = single mandate, only looks at inflation, not concerned with unemployment

Why does a very low unemployment rate led to accelerating inflation?

When there are very few unemployed workers, employers must compete to fill empty job slots. If firms are forced to pay more to their workers, they will try and raise the prices of products, in order to protect their profits.

Why do we not want to be below the natural rate of unemployment?

When unemployment is too low, inflation will rise

When is it safe to exceed the LTSG?

When unemployment is very high, the economy can safely grow faster than the LTSG pace--economic growth produces jobs for both new entrants to the labor force and the cyclically unemployed members of the labor force

adaptive expectations

Workers and firms assume that the future rates of inflation will follow the pattern of rates of inflation in the recent past

Expectations with Moderate but stable inflation

Workers and firms have adaptive expectations

divine coincidence

a phrase coined by Oliver Blanchard, referring to the situation in which a policy meant to stabilize inflation is also the best policy for stabilizing economic activity--NOT true

structural relationship

a relationship that depends on the basic behavior of consumers and firms and that remains unchanged over long periods in the 1960s, some economists argued that the Phillips curve represented a structural relationship in the economy--they believed it represented a permanent trade-off between unemployment and inflation (this is NOT true)

What happens to cyclical unemployment when U is at the natural level?

cyclical unemployment = 0

expansionary monetary policy

monetary policy that increases aggregate demand--real GDP increases and the unemployment rate falls, but at the cost of higher inflation (used to fight high unemployment rate)

Contractionary monetary policy

monetary policy that reduces aggregate demand--real GDP would fall and the inflation would be reduced but at the cost of higher unemployment (used to fight high inflation)

Natural rate of Unemployment

the unemployment rate that exists when the economy is at potential GDP (only structural and frictional unemployment, no cyclical)

What happens when the economy operate below the natural rate?

when the economy is below the natural rate of unemployment, there is great competition for workers. Firms bid up wage rates and soon find they need to raise prices to cover their high labor costs.

Expectations with Low inflation

workers and firms tend to ignore low inflation

Philips Curve Formula

πt = πe + α(U* - Ut) Actual inlfation = expected inflation (inflation for previous year) + alpha(NAIRU - unemployment)

shifts in the short run phillips curve

-by supply shocks (ex: surging oil prices); negative shocks shift it up & positive shocks shift it down -expected inflation rate is MOST important factor affecting inflation; increased expectations shift it up & decreased expectations shift it down (expected change proportional to actual change)

Natural Rate of Unemployment 2019

4%-4.5%

Phillips Curve

A graph showing the relationship between inflation and unemployment. Shows that there is an inverse relationship between unemployment and inflation,

Long-run Phillips Curve

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. Friedman concludes that the long-run Phillips curve is a vertical line at the natural rate of unemployment

Friedman and Phelps

Argued that there is no trade-off between unemployment and inflation in the long run

Paul Volcker

Fed's new chairman--wanted inflation lower. Announced and enacted a contractionary monetary policy (decrease AD). If people believed the announcement, they would adjust down to a lower Phillips curve. But for several years, the Phillips curve appeared not to move. The Fed had a credibility problem: it previously announced contractionary policies, but allowed inflation to occur anyway

Expectations of Future Inflation

If actual inflation is greater than expected inflation, then real wage is less than the expected real wage and the unemployment rate falls. If actual inflation is less than expected inflation, then the actual real wage is greater than the expected real wage, and the unemployment rate rises. Friedman and Phelps concluded that an increase in the inflation rate increase employment only if the increase is unexpected.

the inflation rate and the natural rate of unemployment in the long-run

If unemployment rate < natural rate of unemployment, then the inflation rate increases and the short-run Phillps curve shifts up If unemployment rate > natural rate of unemployment, then the inflation rate decreases and the short-run Phillips curve shifts down (inflation = higher wages = more workers )

Monetary Policy and long-run Phillips Curve

In the long rung, the federal reserve can affect the inflation rate but not the unemployment rate

tight money

Monetary policy that raises interest rates to lower inflation.

Expectations with high and unstable inflation

People must use all available information when forming their expectations fo future inflation--rational expectations

AD/AS and the Phillips Curve

The AS-AS model indicates that slow growth in aggregate demand leads to both higher unemployment and lower inflation

nonaccelerating inflation rate of unemployment (NAIRU)

The unemployment rate at which the inflation rate has no tendency to increase or decrease

Rational expectations

expectations formed by using all available information about an economic variable