AP Economics

Mr. Bernstein Module 34: Inflation and Unemployment: The Phillips Curve April 3, 2014

AP Economics

Mr. Bernstein Inflation and Unemployment: The Phillips Curve

• • • • • Objectives - Understand each of the following: What the Phillips curve is and the nature of the short-run trade-off between inflation and unemployment Why there is no long-run trade-off between inflation and unemployment Why expansionary policies are limited due to the effects of expected inflation Why even moderate levels of inflation can be hard to end Why deflation is a problem for economic policy and leads policy makers to prefer a low but positive inflation rate 2

AP Economics

Mr. Bernstein The Short-Run Phillips Curve

• Review: AD/AS model and tradeoff between inflation and unemployment • SRPC displays the downward sloping • relationship Can extend below X axis but not to the Left of Y axis…why?

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AP Economics

Mr. Bernstein The Short-Run Phillips Curve

• When SRAS curve slides down the AD curve, ie technology breakthrough, SRPC shifts downward 4

AP Economics

Mr. Bernstein Inflation Expectations and the Short-Run Phillips Curve

• Changes in the expected inflation rate cause an • upward shift in SRPC Expected p translates into higher actual p for each level of unemployment • Believed to be 1-for-1 5

AP Economics

Mr. Bernstein The Long Run Phillips Curve

• NAIRU: Non-Accelerating Inflation Rate of Unemployment • Keeping unemployment below NAIRU leads to ever-accelerating p • NAIRU implies there is no long-term trade-off between p and UR 6

AP Economics

Mr. Bernstein The Costs of Disinflation

• What if the government tried to reduce inflation?

• Keep UR > NAIRU, create recession until p subsides • Painful in that it creates higher UR • Example: Voelker 7

AP Economics

Mr. Bernstein Deflation

• Debt Deflation – debts paid with dollars worth more • So borrowers cut back on projects, causing further deflation • Zero Bound - expected deflation causes real interest rates to approach zero and lenders stop lending • Liquidity Trap – Fed can’t cut rates below zero, so Monetary Policy becomes ineffective 8