Transcript File - Ms. Nancy Ware`s Economics Classes

Module 34
Inflation and
Unemployment:
The Phillips
Curve
1.
What is the Phillips curve and the nature of the short-run trade-off between
inflation and unemployment?
2.
Why is there no long-run trade-off between inflation and unemployment?
3.
Why are expansionary policies limited due to the effects of expected
inflation?
4.
Why are even moderate levels of inflation hard to end?
5.
Why is deflation a problem for economic policy? How does this lead policy
makers to prefer a low but positive inflation rate?
•Phillips Curve: shows
relationship between inflation &
unemployment
•Short-Run Phillips Curve:
SRPC
•The role of supply shocks
Short-run trade-off between unemployment & inflation:
Lower unemployment = higher inflation
Higher unemployment = lower inflation
This concept is represented by the graph known as the Phillips curve!
When AD increases along the SRAS, the unemployment rate falls and the
inflation rate rises…
When AD decreases along the SRAS, the unemployment rate rises and the
inflation rate falls…
A shift in AD will cause a movement along the SRPC.
This is what causes a downward sloping relationship between the
unemployment rate and the inflation rate. This is known as the short-run
Phillips curve.
When SRAS increases along the AD (different graph remember?), both the
unemployment and inflation rates fall. This is seen as a downward shift of
the SRPC.
When SRAS decreases along the AD, both the unemployment and inflation
rates rise. This is seen as an upward shift of the SRPC.
When SRAS increases along the AD (draw this graph), both the unemployment and inflation rates fall.
This is seen as a downward shift of the SRPC. Draw this graph.
When SRAS decreases along the AD (draw this graph), both the unemployment and inflation rates rise.
This is seen as an upward shift of the SRPC. Draw this graph.
•Expected Inflation?
•Relationship between actual
and expected inflation?
•What determines expected
inflation?
What is the expected rate of inflation? Why does it
matter?
This is why an increase in expected inflation shifts
the short - run Phillips curve upward: the actual rate
of inflation at any given unemployment rate is
higher when the e______________inflation rate is
higher.
What is the expected rate of inflation? Why does it
matter?
 Inflation that employers & workers expect in the
near future.
 Changes will affect the short-run trade-off
between unemployment and inflation & shift the
short-run Phillips curve.
 Everyone cares about future inflation. If inflation
is expected to be high in the future, wage
contracts will reflect that expectation & nominal
wages will be increased. Nobody wants to lose
purchasing power due to future inflation!!
This is why an increase in expected inflation shifts
the short - run Phillips curve upward: the actual rate
of inflation at any given unemployment rate is
higher when the expected inflation rate is higher.
Why is this so??
Higher inflation expectations shift the SRPC
upward. At any level of unemployment, inflation
will be that much higher.
And lower inflation expectations shift the SRPC
downward.
Why is this so??
Suppose inflation has been near zero for years, but
gradually people begin to expect inflation of 3%.
Nominal wages & other contracts begin to reflect
a future increase of 3%. As these wages and other
resource prices rise by 3%, actual inflation begins
to rise from about zero to 3%. So inflation
expectations translate into actual inflation rates.
Higher inflation expectations shift the SRPC
upward. At any level of unemployment, inflation
will be that much higher.
And lower inflation expectations shift the SRPC
downward.
•
•
•
•
The SRPC of the 1960s
The experience of the 1970s
The trade-off between
inflation & unemployment?
Most macroeconomists
believe that there is, in fact,
no long-run trade-off
between lower
unemployment rates and
higher inflation rates. That is,
it is not possible to achieve
lower unemployment in the
long run by accepting higher
inflation.
The unemployment
rate at which
inflation does not
change over time—
5% in this graph, is
known as the nonaccelerating
inflation rate of
unemployment, or
NAIRU for short.
Keeping the
unemployment rate
below the NAIRU
leads to ever-accelerating inflation
and cannot be
maintained. Most
macroeconomists
believe that there is
a NAIRU and that
there is no long-run
trade-off between
unemployment and
inflation.
•The short run and long run effects of expansionary
policies
•NAIRU
•LRPC
•Natural Rate Hypothesis
•Natural Rate = NAIRU

An effort to reduce unemployment below NAIRU will
cause inflation. What about an effort to reduce inflation?

The government must create a situation, with
contractionary fiscal/monetary policy, where the
unemployment rate is above NAIRU.

This induced recession, should decrease the inflation rate
to the point where the SRPC shifts downward. Once
inflation is under control, the economy can adjust back to
the NAIRU.

This process of disinflation is painful because of a period
of high unemployment.
•
Deflation?
•
Debt Deflation?
•
Effects of Expected Deflation?
•
Zero Bound?
•
Liquidity Trap?
Debt Deflation
Due to the falling price level, a
dollar in the f__________ has a
higher real value than a dollar
t________.
Lenders, who are owed money,
g________under deflation
because the real value of
borrowers’ payments
increases. Borrowers
l________ because the real
burden of their debt rises.
What do you expect borrowers
to do?
Effects of Expected Deflation
Interest rates are affected by
inflation e_____________. What
about deflation?
Nominal rate = r_______ rate +
expected i__________
Suppose the rr=2% and expected
inflation = 3%, then the nominal
rate = 5%.
But what if there is prolonged
deflation and expected inflation
is -2%, the nominal rate is 0%?
Debt Deflation
Due to the falling price level, a
dollar in the future has a
higher real value than a dollar
today.
Lenders, who are owed money,
gain under deflation because
the real value of borrowers’
payments increases. Borrowers
lose because the real burden
of their debt rises.
What do you expect borrowers
to do?
Cut back on spending. So
weak spending causes
deflation, which causes less
spending, which causes
deflation….
Effects of Expected Deflation
Interest rates are affected by
inflation expectations. What
about deflation?
Nominal rate = real rate +
expected inflation
Suppose the rr=2% and expected
inflation = 3%, then the nominal
rate = 5%.
But what if there is prolonged
deflation and expected inflation
is -2%, the nominal rate is 0%?
Interest rates cannot fall below 0%. So
deflation creates a situation where lenders
receive nominal interest rates that
approach zero. Lending will stop. WHY?
This is referred to as the l__________trap.
Interest rates cannot fall below 0%. So
deflation creates a situation where lenders
receive nominal interest rates that approach
zero. Lending will stop. WHY?
If the economy is extremely depressed, which
caused the deflation in the first place, monetary
policy becomes completely ineffective. The Fed
can’t lower the interest rate lower than 0%!!
This kind of deflation can cause an economy to
languish for a very long time.
This is referred to as the liquidity trap.

Module 34 Review Questions p. 341-342

Read Module 35 p. 343-353