Chapter 35 - The Short-Run Trade-off
between Inflation and Unemployment
Phillips curve - shows the short-run trade-off between inflation and
unemployment
•
Inverse relationship, negative correlation between the rate of
unemployment and the rate of inflation
•
Important to policymakers relative to monetary and fiscal policy when
they attempt to influence aggregate demand
•
Initially, policymakers assumed it offered a menu of options, choose
any point on Phillips curve to control unemployment
•
Trade-off: High unemployment and low inflation or low unemployment
and high inflation
The Phillips Curve
Inflation
Rate
(percent
per year)
B
6%
A
2%
Phillips curve
4%
7%
Unemployment
Rate (percent)
The Phillips curve illustrates a negative association between the inflation rate and the unemployment
rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and
unemployment is low.
2
The Phillips Curve
Aggregate demand (AD), aggregate supply (AS), and the Phillips curve
◦ Shifts in the aggregate-demand curve push inflation and
unemployment in opposite directions in the short run
 Higher aggregate-demand
◦ Higher output & Higher price level
◦ Lower unemployment & Higher inflation
 Lower aggregate-demand
◦ Lower output & Lower price level
◦ Higher unemployment & Lower inflation
3
How the Phillips curve is related to the model of aggregate
demand and aggregate supply
(b) The Phillips Curve
(a) The Model of AD and AS
Price
level
SRAS
B
106
Inflation
Rate
(percent
per year)
6%
AD2
A
102
B
A
2
AD1
Phillips curve
0
15,000
unemployment
=7%
16,000
unemployment
=4%
Quantity
of output
0
7%
4%
output output
=16,000 =15,000
Unemployment
Rate (percent)
4
Long-Run Phillips Curve

The long-run Phillips curve is vertical
◦ Unemployment - does not depend on money growth and inflation in the long run
◦ We always return to the “natural rate of unemployment”, but at a higher price
level
◦ If the Fed increases the money supply
 In the short run, unemployment will fall, but inflation rate is high
 In the long run unemployment will return to its natural rate
Inflation
Long-run
Rate
Phillips curve
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
High
inflation
B
2. . . . but unemployment
remains at its natural rate
in the long run.
Low
inflation
A
Natural rate of
unemployment
Unemployment
Rate
5
Long-Run Phillips Curve

The long-run Phillips curve is the expression of the classical idea of
monetary neutrality
◦ Increase in money supply
 Interest rates decline and the aggregate-demand curve – shifts right
 Price levels (inflation) increase and unemployment decreases in the
short-run
 Long-run – people come to expect inflation and output returns to
natural rate, along with unemployment
6
Long-Run Phillips Curve and LRAS
•
Price
Level
The economy experiences a boom, people have more disposable income to spend
Inflation
Rate
Quantity of Output
(Real GDP)
0
Unemployment
Rate
Long-Run Phillips Curve and LRAS
•
Price
Level
The economy experiences a boom in the stock market, people have more disposable
income to spend
LRPC
LRAS
SRAS2
Inflation
Rate
SRAS1
P3
P2
C
9%
B
C
B
6%
A
A
3%
P1
SRPC2
SRPC
AD1
Yf
Y2
AD2
Quantity of Output
(Real GDP)
0
3%
Yf
5%
Unemployment
Rate
Long-Run Phillips Curve and LRAS
•
Price
Level
The economy experiences a recession due to reductions in AD.
Inflation
Rate
0
Quantity of Output
(Real GDP)
Unemployment
Rate
Long-Run Phillips Curve and LRAS
•
The economy experiences a recession due to reductions in AD.
Price
Level
LRPC
LRAS
Inflation
Rate
SRAS1
SRAS2
A
P1
P2
P3
B
2%
B
C
AD2
Yf
SRPC
1%
C
Y2
A
3%
AD1
Quantity of Output
(Real GDP)
0
Yf
5%
SRPC2
Unemployment
Rate
8%
•
Long-Run Phillips Curve and LRAS
Scenario: The government adopts expansionary fiscal policy because of political pressures and
cuts taxes. Show how shifts in the AD curve will affect the Phillips curve. Use 2% as the equilibrium
inflation rate and 5% as the natural rate of unemployment. Use 5% inflation after the economy
experiences the increase in AD. To fix the inflation problem, the government raises taxes back to
their normal rate
Price
Level
LRAS
LRPC
Inflation
Rate
SRAS1
P2
B
B
5%
A
P1
A
2%
SRPC
AD1
Yf
Y2
AD2
Quantity of Output
0
3%
Yf
5%
Unemploymen
Rate
•
Long-Run Phillips Curve and LRAS
Scenario: The government adopts expansionary fiscal policy because of political pressures and
cuts taxes. Show how shifts in the AD curve will affect the Phillips curve. Use 2% as the equilibrium
inflation rate and 5% as the natural rate of unemployment. Use 5% inflation after the economy
experiences the increase in AD. To fix the inflation problem, the government raises taxes back to
their normal rate
Price
Level
Inflation
Rate
0
Real GDP
(Quantity of Output)
Unemployment Rate
Long-Run Phillips Curve and LRAS
•
Scenario: Assume long run equilibrium. There is an embargo placed on the
United States by OPEC nations. Show how shifts in the SRAS curve will affect the
Phillips curve. The government increases spending to get unemployment and
production back to its natural rate.
Price
Level
LRAS
LRPC
SRAS2
Inflation
Rate
SRAS1
P3
P2
C
C
B
9%
B
5%
A
P1
A
2%
SRPC2
AD2
SRPC
AD1
Y2
Yf
Quantity of Output
0
Yf
5%
Y2
7%
UR
•
Long-Run Phillips Curve and LRAS
Scenario: Assume long run equilibrium. There is an embargo placed on the United States by
OPEC nations. Show how shifts in the SRAS curve will affect the Phillips curve. The
government increases spending to get unemployment and production back to its natural
rate.
Price
Level
Inflation
Rate
0
Real GDP
(Quantity of Output)
Unemployment Rate
Shifts in Phillips Curve: Role of Expectations

Rational Expectations – people will adjust their behavior to expectations of
inflation.

Shifts in AD causes movement along the short-run Phillips curve
◦ Shifts to the right cause inflation to increase and unemployment to decrease
◦ Shifts to the left cause inflation to decrease and unemployment to increase
Shifts in Phillips Curve: Role of Expectations

Shifts in SRAS cause a shift in the SRPC
◦ Shifts to the right in SRAS cause shifts to the left in the SRPC
◦ Shifts to the left in SRAS cause cause shifts to the right in the SRPC
◦ SRAS and SRPC are mirror images of each other
Long-Run Phillips Curve Application
Scenario: A country’s economy is in a short-run equilibrium with an output level less than the fullemployment output level.(recession). Assume an upward-sloping aggregate supply curve.
(a) Using a correctly labeled aggregate demand and aggregate supply graph, show the following.
(i) Full-employment output, labeled as YF
(ii) Equilibrium real output and price level, labeled as YE and PLE, respectively
(b) Assume that the country’s government increases domestic military expenditures. On the graph
from part (a), show how the increased military expenditures affect the following in the short run.
(i) Aggregate demand
(ii) Equilibrium real output and price level, labeled as Y2 and PL2, respectively
(c) Using a correctly labeled graph of the short-run Phillips curve, show the effect of the increased
military expenditures in the short run, labeling the initial point as A and the new point as B.
Long-Run Phillips Curve Application
Scenario: Assume that the United States economy is in long-run equilibrium with
an expected inflation rate of 6 percent and an unemployment rate of 5
percent.
(a) Using a correctly labeled graph with both the short-run and long-run Phillips
curves and the relevant numbers from above, show the current long-run
equilibrium as point A.
Long-Run Phillips Curve Application
The unemployment rate in the country of Southland is greater than the
natural rate of unemployment.
(a) Using a correctly labeled graph of aggregate demand and aggregate supply,
show the current equilibrium real gross domestic product, labeled YC, and
price level in Southland, labeled PLC. The president of Southland is receiving
advice from two economic advisers—Kohelis and Raymond—about how
best to reduce unemployment in Southland.
(b) Kohelis advises the president to decrease personal income taxes.
(i) How would such a decrease in taxes affect aggregate demand? Explain.
(ii) Using a correctly labeled graph of the short-run Phillips curve, show the
effect of the decrease in taxes.
Label the initial equilibrium from part (a) as point A, and the new equilibrium
resulting from the decrease in taxes as point B.
(c) Raymond advises the president to take no policy action.
(i) What will happen to the short-run aggregate supply curve in the long run?
Explain.
(ii) Using a new correctly labeled graph of the short-run Phillips curve, show
the effect of the change in the short-run aggregate supply you identified in
part (c)(i).
Chapter 35 Mankiw Application Worksheet
1.
Describe the initial effect of the following events on the short-run
and long-run Phillips curve. That is, describe the movements along a
given curve or the direction of the shift in the curve.
a. An increase in expected inflation causes people to demand higher
wages causing firms to decrease production
a. Shifts short-run Phillips curve to the right (upward).
b. An increase in the price of imported oil
b. Shifts short-run Phillips curve to the right (upward).
c. An increase in the money supply causing unexpected inflation
c. Movement along and up the short-run Phillips curve.
d. A decrease in government spending
d. Movement along and down the short-run Phillips curve.
e. A decrease in the minimum wage, which lowers the natural rate
unemployment
e. Long-run and short-run Phillips curves shift left (downward).
Chapter 35 Mankiw Application Worksheet
a.
At what point is the economy located if people expect 10 percent inflation and
inflation actually is 10 percent?
a. Answer: E
b.
Referring to (a) above, is unemployment above, below, or equal to the natural
rate?
b.
c.
At what point is the economy located if people expect 10 percent inflation
and the actual rate of inflation is 15 percent?
c.
d.
Answer: Right.
Suppose the economy is operating at point E. In the short run, a sudden
decrease in aggregate demand will move the economy toward which point?
f.
g.
Answer: Up.
Suppose the economy is operating at point D. As people revise their
expectations of inflation, in which direction will the short-run Phillips curve
shift-right or left?
e.
f.
Answer: D.
Suppose the economy is operating at point D. Over time, in which direction
will people revise their expectations of inflation: up or down?
d.
e.
Equal to the natural rate.
Answer: F.
Suppose the economy is operating at point E. In the long run, a decrease in
government spending will tend to move the economy toward which point?
g. Answer: H.
h.
Suppose people expect 5 per cent inflation. If inflation actually ends up being
10 per cent, in which direction will unemployment move: above or below the
natural rate?
h. Answer: Below the natural rate.
Chapter 35 Mankiw Application Worksheet
3.
Use a Phillips curve graph to answer the following questions. Assume the
economy is initially in long-run equilibrium.
a.
What happens to an economy’s unemployment and inflation rate in the short
run if the central bank increases the growth rate of the money supply
a.
b.
What happens to an economy’s unemployment and inflation rate in the long
run if the central bank increases the growth rate of the money supply
b.
c.
Answer: Inflation increases, unemployment stays at the natural rate.
Can printing money keep unemployment below the natural rate? Explain.
c.
d.
Answer: Inflation increases, unemployment decreases.
Answer: No. Unemployment temporarily decreases, but as people grow to expect the higher
inflation, unemployment returns to the natural rate.
What is the end result of a central bank repeatedly attempting to hold
unemployment below the natural rate with expansionary monetary policy?
Explain.
d.
Answer: Continued attempts to move unemployment below the natural rate simply causes
inflation.
2011
(ii)One point is earned for stating that the Federal Reserve should buy bonds.
(iii) Price level will increase because the Federal Reserve action increases interestsensitive spending (e.g., investment and consumption) and aggregate demand.
• One point is earned for stating that the short-run aggregate supply will increase (shift
right) because wages and other input prices will decrease.
• One point is earned for stating that the natural rate of unemployment remains
unchanged.
2011 (B)
2011 (B)
2011 (B)
One point is earned for stating that transfer payments will increase because more
people will apply for government benefits.
2011 (B)
2011 (B)
One point is earned for stating that the short-run aggregate supply curve will shift to
the right because wages and other input costs will fall.
2010
• One point is earned for stating that
investment spending will decrease.
• One point is earned for explaining that the
decrease in investment slows down capital
deepening, leading to a reduction in the
economic growth rate.
Free Responses
2005
 2006 (1)
 2006 (3)
 2006 b
 2008
 2009 (a)
 2009 (b)

Binder Check
1.
2.
3.
4.
5.
Monetary and Fiscal Policy Scenarios
Free Response Station Work
Daily Tens
Terms
Notes
Upcoming Assignments
1.
2.
3 Online lecture videos and quizzes – due
Thursday.
Prequiz, Chapters 31-32 due Friday.
One point is earned for the correct calculation
of the real interest rate: 8% - 6% = 2%.
One point is earned for stating that the Federal Reserve should sell bonds.
•One point is earned for stating that aggregate demand decreases.
•One point is earned for explaining that the higher interest rate decreases investment
and interest-sensitive consumption spending, and that both consumption and
investment are components of aggregate demand.
• One point is earned for stating that the short-run Phillips curve will shift to the left, or
movement along the curve towards recessionary conditions.
• One point is earned for explaining that Federal Reserve policy will lower inflationary
expectations so the economy will slow.
• One point is earned for stating that the natural rate of unemployment will remain
unchanged in the long-run.