CH. 21 - REVISITING INFLATION, UNEMPLOYMENT,...
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MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
CONCEPT: SHORT-RUN PHILLIPS CURVE
● Two of the main macroeconomic concerns for policy makers are unemployment and inflation
□ However, it is hard to control both at the same time!
> If Aggregate Demand increases Price Level ____ and Unemployment ____
> If Aggregate Demand decreases Price Level ____ and Unemployment ____
EXAMPLE: Assume Year 1 is the base-year (price level = 100) and we are analyzing possible situations for Year 2.
Short-Run Phillips Curve
AD-AS Model Short-Run Phillips Curve
□ Phillips Curve – a graph showing the relationship between the _______________ and _______________
> As inflation increases, unemployment ________________
> As inflation decreases, unemployment ________________
ADH
ADL
SRAS
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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CONCEPT: LONG-RUN PHILLIPS CURVE
● Two of the main macroeconomic concerns for policy makers are unemployment and inflation
□ Recall, in the long run, the economy is functioning at its ______________ GDP
> Natural Rate of Unemployment – unemployment rate when economy is at ______________ GDP
> NAIRU – unemployment rate at which inflation has no tendency to increase or decrease
- Non-accelerating inflation rate of unemployment
> If Aggregate Demand increases Price Level ____ and Unemployment ____
> If Aggregate Demand decreases Price Level ____ and Unemployment ____
Long-Run Phillips Curve
AD-AS Model Long-Run Phillips Curve
AD2
AD1
LRAS
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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CONCEPT: SHIFTS IN SHORT-RUN PHILLIPS CURVE AND EXPECTED INFLATION
● Two of the main macroeconomic concerns for policy makers are unemployment and inflation
□ However, it is hard to control both at the same time!
□ The position of the short-run Phillips Curve is related to ____________ inflation
𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 =𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒
𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙
The real wage (purchasing power) adjusts the amount of dollars you are actually paid for the price level in the economy
- (i.e. The same nominal wage will buy less stuff at higher prices) If workers and firms expect a certain level of inflation (say 1.5%), but a higher inflation rate occurs (say 4.5%):
Expected Real Wage _____ Actual Real Wage
Firms will hire _______ workers leading to ________ unemployment
Price Level _____ and Unemployment ______, but ONLY because the inflation was ________________
If the new inflation rate (i.e. 4.5%) persists, it becomes the expected level of inflation Shifts the SR Phillips Curve Rational Expectations Theory – when forecasting the future, people use all publicly available information
- In this case, people are making rational decisions about the level of expected inflation
Long-Run Phillips Curve
Exp. Inflation = 1.5%
LR Phillips Curve
Exp. Inflation = 4.5%
5%
1.5%
4.5%
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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CONCEPT: SUPPLY SHOCK AND THE PHILLIPS CURVE
● Supply Shocks – an unexpected event that affects a firm’s production costs and shifts aggregate ___________
□ Generally, a supply shock involves an unexpected increase in input prices (like gasoline)
EXAMPLE: A sudden increase in gas prices affects the input costs of firm’s production
Short-Run Phillips Curve
AD-AS Model Short-Run Phillips Curve
□ Aggregate supply ____ Output ____ and Price Level _____
- This leaves policymakers in the difficult position of fighting _______ inflation and _______ unemployment
AD
SRAS
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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CONCEPT: SACRIFICE RATIO
● Expectations about inflation rates are a determinant of the position of the short-run Phillips Curve
□ If expected inflation increases Shift ___________
□ If expected inflation decreases Shift ___________
● The expected inflation in the economy has implications throughout:
□ Nominal Interest Rate vs. Real Interest Rate
- If expected inflation increases, nominal interest rates will also increase to stabilize the real interest rate
Assume the real interest rate a bank wants to earn is 5% on a loan. If expected inflation is equal to 2%, then: Now assume that expected inflation increases to 4%. To maintain the same real interest rate the bank would:
● If the Fed wishes to reduce the inflation rate, they must pursue ____________________ monetary policy
□ Money Supply ____ Interest Rates ____ Aggregate Demand ____ Price Level ____ and GDP ____
□ Sacrifice Ratio – percentage of GDP lost in the process of lowering inflation by 1%
𝑆𝑎𝑐𝑟𝑖𝑓𝑖𝑐𝑒 𝑅𝑎𝑡𝑖𝑜 =%∆𝐺𝐷𝑃
%∆𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
Sacrifice Ratio
LRPC
SRPC1
1. Contractionary policy
moves economy down
the SR Phillips Curve
2. In the LR, expected
inflation decreases, and
SR Phillips Curve shifts
left
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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CONCEPT: DISINFLATION AND DEFLATION
● Disinflation – a significant reduction in the _________________
□ Note that inflation is still _____________ during disinflation, but at a __________ rate
□ Historical context: USA in the 1970s-1980s and Paul Volcker Disinflation
● During the 1970s, the USA experienced high inflation rates
US Inflation Rates
Source: Bureau of Labor Statistics
● In 1979, President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserve
□ Volcker’s strict anti-inflation monetary policy brought inflation down from 10% down to 4%
□ Contractionary monetary policy brought inflation down, but increased short run unemployment (see graph below)
□ As workers and firms lowered their expectations of future inflation, the SR Phillips curve shifted left (same graph)
● Fiscal policy during the Reagan era of the 1980s did not help combat inflation
□ Increases in the budget deficit through increased spending, led to higher aggregate demand more inflation
Phillips Curve and Contractionary Policy
LRPC
SRPC1
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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● Deflation – a decline in the price level
□ During deflation, the inflation rate is _____________
□ Note the difference between disinflation and deflation
> Disinflation – inflation still occurring but at a slower rate
> Deflation – lower price level in the economy
Year Consumer Price Index
Inflation Rate
1929 17.1 0.0%
1930 16.7 -2.3%
1931 15.2 -9.0%
1932 13.7 -9.9%
1933 13.0 -5.1%
1979 72.6 11.3%
1980 82.4 13.5%
1981 90.9 10.3%
1982 96.5 6.2%
1983 99.6 3.2%
MACROECONOMICS - CLUTCH
CH. 21 - REVISITING INFLATION, UNEMPLOYMENT, AND POLICY
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