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Chapter 27, Section 27.1, In Text Question, Exercise 01

# Why is there a possible short-run relationship between the inflation rate and the unemployment rate?

### Explanation

SOLUTION

From the information in the question above, we can analyze the scenario and solve the problem given as follows.

To begin with;

The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.

Historically, inflation and unemployment have maintained an inverse relationship, as represented by the Phillips curve. Low levels of unemployment correspond with higher inflation, while high unemployment corresponds with lower inflation and even deflation. From a logical standpoint, this relationship makes sense. When unemployment is low, more consumers have discretionary income to purchase goods. Demand for goods rises, and when demand rises, prices follow. During periods of high unemployment, customers purchase fewer goods, which puts downward pressure on prices and reduces inflation.

An increase in the aggregate demand for goods and services leads, in the short run, to a larger output of goods and services and a higher price level: the larger output lowers unemployment, but the higher prices is inflation.