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Unformatted text preview: UNIVERSITY OF CALIFORNIA, BERKELEY Dorian Carloni Department of Economics ECON 100B, Fall 2011 SECTION 16: The Phillips Curve and Aggregate Supply 16.1. The Phillips Curve & The short run Phillips curve we are working with is an expectation augmented version of the Phillips curve in which expected in&ation is adaptive and we allow for the possibility of supply shocks: & t = & t & 1 ! ( U t U N ) + t where: & t = in&ation rate at time t & t & 1 = in&ation rate at time t-1 ! = the sensitivity of to changes in U U t = the unemployment rate at time t U N = the natural rate of unemployment t = supply shock (if no supply shock at time t, then t = 0) & What the formula tells us: 1. inverse relationship between in&ation and the unemployment gap : when unemployment is unusu- ally low (below U N ), the demand for labor will exceed the supply of labor and wages will rise more quickly. Because wages are a major input into total costs, more rapidly rising wages leads to higher in&ation. 2. positive one-for-one relationship between in&ation and expected in&ation : nominal wages wont change only as a result of changes in unemployment, but also if workers and businesses expect in&ation to increase, as they will also adjust nominal wages higher so that the real wage does not fall. Specically, we are assuming that in&ation expectations are determined in an adaptive (or backward-looking) way: & e = & t & 1 : 3. the Phillips curve has also been adjusted to account for supply shocks , i.e. events that aect in&ation that are independent of: (a) Labor market conditions, and/or...
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