CHAPTER 8 (Ch 35-36)

THE SHORT-RUN TRADE OFF BETWEEN INFLATION AND UNEMPLOYMENT & SIX DEBATES OVER
MACROECONOMIC POLICY

THE PHILLIPS CURVE

• Phillips curve is the short-run relationship between inflation and unemployment, which is a
trade-off

• Determinant for variables in the Phillips curve Unemployment: labor market

Inflation: money supply

1. Origin of Phillips Curve

↓ unemployment → ↑ inflation,

↑ unemployment → ↓ inflation.

low unemployment → high aggregate demand → ↑ wages

and prices (↑ inflation)

2. Aggregate Demand, Aggregate Supply, and The Phillips Curve

• Aggregate demand and aggregate supply can determine how much price and how much quantity
produced in the economy. Price can determine the inflation and quantity can determine the
unemployment rate

This figure shows how aggregate demand and aggregate supply (A) can move the Phillips curve (B).
 High AD Low AD

↑ AD→ ↑ Q → ↑P ↓ AD→ ↓Q → ↓P

↑ Q → ↓ rate of unemployment ↓ Q → ↑ rate of unemployment

↑ P = ↑ inflation ↓ P = ↓ inflation

• Monetary and fiscal policy can move along an economy in Phillips curve because they can shift AD
curve

SHIFT IN PHILLIPS CURVE

1. Role of Expectation

• Long-Run Phillips Curve

The vertical long- run Phillips
curve illustrate monetary
neutrality, there is no trade-off
between inflation and
unemployment.

o In the long run, regardless of the inflation rate, output is at its natural level and
unemployment is at its natural rate.
o Natural means a steady state, it represents the hypothetical unemployment rate
consistent with aggregate production being at the "long-run" level.
 • Short-Run Phillips Curve

Unemployment Rate = Natural Rate of Unemployment – α (Actual inflation – expected inflation)

• This equation implies there is no stable short-run Phillips curve. Each SR Phillips curve
reflects an expected rate of inflation.
• SR Phillips curve intersects with LR Phillips curve at the expected rate of inflation.
• When expected inflation changes, the short-run Phillips curve shifts.
• The higher the expected rate of inflation means the curve is more representing the SR trade-
off between inflation and unemployment

This figure shows people get used to higher inflation rate → higher expectations of inflation. With
higher expected inflation, firms and workers setting higher wages and prices.

• SR Phillips curve → shifts to the right.

Causing higher inflation without any reduction in unemployment.

2. Role of Supply Shock

This figure shows how aggregate demand and aggregate supply (A), when there is a shock in AS curve,
can shift the Phillips curve (B).

• The SR Phillips curve can also shift because shock of aggregate supply.
 • A supply shock directly affect firm’s costs of production, causing a change in price.
• A change in supply shock (ex: adverse supply shock) → shift the SRAS curve to the left,
causing the price rise and quantity falls
• The shift in SRAS causing change in Phillips curve, shifting the SR Phillips curve to the right,
causing inflation and unemployment rise.

COST OF REDUCING INFLATION

1. Sacrifice Ratio
the number of percentage points of annual output lost in the process of reducing inflation by one
percentage point
• Central bank must pursue contractionary monetary policy, and will contract aggregate demand

• When the Fed slows the growth of money supply, it contracts aggregate demand. Contract
aggregate demand leads to reducing the quantity of goods and services that firm produces, causing
unemployment to rise

2. Rational Expectation
the theory that people optimally use all the information they have, including information about
government policies, when forecasting the future
 SIX DEBATES OVER MACROECONOMIC POLICY

PRO CON
Should Monetary and Fiscal
Economies fluctuate on their own Stabilization policy does not affect
Policymakers Try to Stabilize
and more stable economy benefits the economy immediately because it
the Economy?
everyone, so stabilization policy is has lags and the economy can
needed readjust itself
SPENDING TAX CUT
Should the Government
Fight Recessions with Government spending directly adds Tax cut can increase both AD and AS.
Spending Hikes Rather Than AD, if the government gives tax cuts, Rapid government spending may be
Tax Cuts? the cuts may rather be saved than wasteful and require future tax
spent increases
PRO-DISCRETION
ANTI-DISCRETION (RULE)
Should Monetary Policy Be
Discretion can leads to abuse of Discretion have flexibility to react in
Made by Rule Rather Than
power, incompetence, and also unforeseen events, time-
by Discretion?
time-inconsistency inconsistency & political business
cycles problems are not clear

PRO CON
Should the Central Bank
Zero inflation has costs that only The benefits of zero inflation are
Aim for Zero Inflation?
temporary, but the result has rather small, but the costs of reaching
permanent benefits zero inflation are large.
PRO
CON
Should the Government
Debt place burden in future taxpayers,
Balance Its Budget? Cutting budget deficit can also lower
inheriting large debt will lower the
welfare (education, health, etc)
future living standard
PRO CON
Should the Tax Laws Be
Reformed to Encourage High saving means high investment, Increasing the incentive to save
Saving? which can leads to raise in labor means increasing the tax burden on
production, wages, and income those who can least afford it.