chap_15_macro

chap_15_macro - CHAPTER 16 Inflation, Unemployment, and...

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310 CHAPTER 16 Inflation, Unemployment, and Federal Reserve Policy 1. Chapter Summary 2. Learning Objectives 3. Chapter Outline Teaching Tips/Topics for Discussion 4. Solved Problems 5. Solutions to Review Questions and Problems and Applications 1. Chapter Summary There is an important relationship between inflation and unemployment. The Phillips curve illustrates the short-run trade-off between the unemployment rate and the inflation rate. The inverse relationship between unemployment and inflation shown by the Phillips curve is consistent with the aggregate demand and aggregate supply analysis. The AD-AS model indicates that slow growth in aggregate demand leads to both higher unemployment and lower inflation, and rapid growth in aggregate demand leads to both lower unemployment and higher inflation. It is essential to understand the relationship between the short-run and long-run Phillips curves. The relationship between the short-run and long-run Phillips curves depends on the expected inflation rate. Each short-run Phillips curve intersects the long-run Phillips curve. With a vertical long-run Phillips curve, it is not possible to buy a permanently lower unemployment rate at the cost of a permanently higher inflation rate. If the expected inflation rate increases, the short-run Phillips curve will shift up and push the economy back to the natural rate of unemployment. The reverse happens if the Fed attempts to keep the economy above the natural rate of unemployment. In the long run, the Federal Reserve can affect the inflation rate but not the unemployment rate. Inflationary expectations can affect the monetary policy. There are two types of expectations of the inflation rate that affect monetary policy. Workers and firms tend to have adaptive expectations when the inflation rate is moderate and stable. This is because they assume that future inflation rates will follow the pattern of inflation rates of the past. Robert Lucas and Thomas Sargent argued that workers and firms would have rational expectations . These are formed by using all available information about an economic variable, including the effect of the policy being used by the Federal Reserve. The Federal Reserve can permanently lower the inflation rate. The Fed used contractionary monetary policy to reduce inflation, which also pushed the economy down the short-run Phillips curve. As workers and firms lowered their expectations of future inflation, the short-run Phillips curve shifted
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Inflation, Unemployment, and Federal Reserve Policy 311 down, improving the short-run trade-off between unemployment and inflation. This change in expectations allowed the Fed to switch to an expansionary monetary policy to bring the economy back to the natural rate of unemployment. Some economists and policy makers believe a central bank’s credibility is increased if it follows a rules strategy for monetary policy. Other economists and policy makers support a discretion strategy for monetary policy, under which the central bank adjusts monetary policy as it sees
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This note was uploaded on 09/23/2011 for the course ECO 1123 taught by Professor Josephlichter during the Spring '11 term at FIU.

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chap_15_macro - CHAPTER 16 Inflation, Unemployment, and...

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