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>> Labor Markets, Unemployment, and Inflation Section 4: Unemployment and Inflation: The Phillips Curve chapter 15 Earlier in this chapter we saw that in 1978, when the Humphrey–Hawkins bill set a target unemployment rate of 4%, many economists were concerned: they feared an attempt to achieve that target would lead to high and accelerating inflation. What was the basis for these concerns? We’ve seen part of the answer: 4% was well below estimates of the natural rate of unemployment. But what’s wrong with trying to keep unemployment below the nat- ural rate? To answer that question we need to look at the relationship between unem- ployment and inflation. The Short-Run Phillips Curve In a famous 1958 paper the New Zealand–born economist A. W. H. Phillips found that historical data for the United Kingdom showed that when the unemployment
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2 CHAPTER 15 SECTION 4: UNEMPLOYMENT AND INFLATION: THE PHILLIPS CURVE rate is high, the wage rate tends to fall, and when the unemployment rate is low, the wage rate tends to rise. Using data from Britain, the United States, and elsewhere, other economists soon found similar patterns between the unemployment rate and the rate of inflation—that is, the rate of change in the overall price level. The negative short-run relationship between the unemployment rate and the inflation rate is called the short-run Phillips curve, or SRPC. (We’ll explain the difference between the short run and the long run in a little while.) Figure 15-5 shows a hypothetical short-run Phillips curve. Why is there a negative short-run relationship between the unemployment rate and the inflation rate? Recall the short-run aggregate supply curve from earlier chapters. The SRAS curve shows that when a rightward shift of the aggregate demand curve leads to an increase in the aggregate price level, real GDP increases as well. In other words, there is a positive relationship between the aggregate price level and real GDP. But how does this relate to unemployment? Remember that there is a negative rela- tionship between real GDP and the unemployment rate: Okun’s law tells us that when real GDP is higher than potential output, the unemployment rate will be lower than when real GDP is below potential output. So increases in the aggregate price level are associated with increases in real GDP, which in turn tend to lead to lower unemployment rates. The relationship between the short-run Phillips curve and the short-run aggregate supply curve is a bit trickier than presented here. Specifically, this discussion describes a relationship between changes in the unemployment rate and inflation; the short-run Phillips curve, however, describes a relationship between the level of the unemploy- ment rate and inflation. The short-run Phillips curve relationship itself, however, is very intuitive. In gen-
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This note was uploaded on 04/10/2008 for the course ECONOMICS 103 taught by Professor Sheflin during the Spring '08 term at Rutgers.

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