Transcript Short-run Policy Tradeoff

Short-run Policy Tradeoff
Chapter 17
Short-run Phillips Curve
• A curve showing the relationship between the
inflation rate and the unemployment rate in the
short run
– Assuming the natural rate of unemployment and the
expected inflation rate is unchanged.
– It shows tradeoff between inflation and unemployment
(The lower inflation rate, the higher rate of
unemployment).
• New Zealand economist Phillips discovered this
relationship from the 100 years U.K. data in
1958.
Short-run Phillips Curve
Continued
• Okun’s law
– For every percentage point that the
unemployment rate is above the natural rate
of unemployment, there is two percent gap
between real GDP and potential GDP.
• The short-run Phillips curve is another way
of presenting the AS curve.
• Shift of the short-run Phillips curve
– Caused by changes in the natural rate of
unemployment or expected inflation rate.
Long-run Phillips Curve
• A vertical line the relationship between the
inflation rate and the unemployment rate in the
long run
– Assuming the economy is at full employment.
– It shows no tradeoff between inflation and
unemployment.
• Any attempt to lower unemployment below the
natural rate will only result in higher inflation
without success in lowering unemployment in
the long run.
Natural Rate Hypothesis
• The proposition that any change in
unemployment due to money supply growth is
only temporary and eventually the natural rate of
unemployment prevails.
• Money supply growth  expected inflation rate
increase, and the short-run Phillips curve shifts
up (or rightward).
• So, tradeoff along the short-run Phillips curve is
temporary.
• No tradeoff along the long-run Phillips curve.
Natural Unemployment Rate
• Does it change? Yes.
– Increase in the 70s due to the baby boom
generation entering the labor force and the oil
crises.
– Decrease in the 80s and 90s due to the baby
bust generation entering the labor force and
technology innovation
• What happens to the Phillips curve?
– Both the short-run and long-run Phillips
curves shift rightward.
Expected Inflation Rate
• What is it?
– The inflation rate that people forecast and use to set
the money wage and other money price
• What determines it?
– Past inflation and the Fed’s monetary policy
– People have rational expectation
• Using all the relevant data and economic science
• What happens to the Phillips curve?
– Gradual shift of the short-run Phillips curve
• How to lower expected inflation?
– By lowering actual inflation rates over time.
• Surprise reduction vs. credible announced reduction