Chapter_16.docx

Chapter_16.docx - Chapter 16 Inflation, Unemployment, and...

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Chapter 16 Inflation, Unemployment, and Federal Reserve Policy The Discovery of the Short-Run Trade-off between Unemployment and Inflation A. Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves There is a short-run trade-off between unemployment and inflation: Higher unemployment is usually accompanied by lower inflation, and lower unemployment is usually accompanied by higher inflation. The Phillips curve is a curve showing the short-run relationship between the unemployment rate and the inflation rate. The inverse relationship between unemployment and inflation that Phillips discovered is consistent with the aggregate demand and aggregate supply analysis. B. Is the Phillips Curve a Policy Menu? Some economists argued during the 1960s that the Phillips curve represented a structural relationship in the economy. A structural relationship depends on the basic behavior of consumers and firms and remains unchanged over long periods.
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Structural relationships are useful in formulating economic policy because the relationships will not change as a result of changes in policy. Many economists and policymakers in the 1960s viewed the Phillips curve as a structural relationship and believed it represented a permanent trade-off between unemployment and inflation. C. Is the Short-Run Phillips Curve Stable? In 1968, in his presidential address to the American Economic Association, Milton Friedman of the University of Chicago (who would go on to win the Nobel Prize in Economics) argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. D. The Long-Run Phillips Curve At potential real GDP (long-run level), firms will operate at their normal level of capacity, and everyone who wants a job will have one, except the structurally and frictionally unemployed. Friedman defined the natural rate of unemployment as the unemployment rate that exists when the economy is at potential GDP. The actual unemployment rate will fluctuate in the short run but will always come back to the natural rate in the long run. If the long-run Phillips curve is a vertical line, no trade-off exists between unemployment and inflation in the long run .
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E. The Role of Expectations of Future Inflation A higher inflation rate can lead to lower unemployment if both workers and firms mistakenly expect the inflation rate to be lower than it turns out to be. Expected inflation increases the value of total production and the value of total income by the same amount. If actual inflation is higher than expected inflation, actual real wages in the economy will be lower than expected real wages, and many firms will hire more workers than they had planned to hire, causing the unemployment rate to fall. An increase in the inflation rate increases employment (and decreases unemployment) only if the
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This note was uploaded on 02/25/2010 for the course ECON 2010 taught by Professor Roussel during the Spring '08 term at LSU.

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Chapter_16.docx - Chapter 16 Inflation, Unemployment, and...

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