Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Unemployment and Inflation 
depends on various features of the
labor market.
efficiency wages, and the effectiveness
of job search.
 
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Unemployment and Inflation 
on growth in the quantity of money,
controlled by the ed.
!health" of the economy, adds together
the inflation rate and unemployment
rate.
 
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Unemployment and Inflation
unemployment and inflation.
but only at the cost of higher inflation.
$f they contract aggregate demand, they
can lower inflation, but at the cost of
temporarily higher unemployment.
 
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The Phillips Curve
short-run relationship between
inflation and unemployment.
 
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The Phillips Curve...
Unemploymen t Rate
 
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Areate !emand" Areate
Supply" and the Phillips Curve
The %hillips curve shows the short-run
combinations of unemployment and
aggregate demand curve move the
economy along the short-run aggregate
supply curve.
 
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Areate !emand" Areate
Supply" and the Phillips Curve
The greater the aggregate demand for
goods and services, the greater is the
economy&s output, and the higher is the
overall price level.
level of unemployment.
 
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#ow the Phillips Curve is Related to the $odel
of Areate !emand and Areate Supply...
Phillips curve
Price evel
Low AD
High AD
 
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Shifts in the Phillips Curve%
The Role of &'pe(tations
policymakers a menu of possible
inflation and unemployment outcomes.
 
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The )on-Run Phillips Curve
$n the ()*+s, riedman and %helps
concluded that inflation and
run.
vertical at the natural rate of unemployment.
onetary policy could be effective in the
short run but not in the long run.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The )on-Run Phillips Curve...
Unemployme nt Rate
Phillips curve
B 1i/h
infation 1. When the Fed increases the growth rate of the mone suppl! the rate of in"ation increases#
$. # %ut unemplomen t remains at its natural rate in the long run.
Ao
1  
(a) !he #o$el o% A//re/ate &eman$ an$ A//re/ate
'upply
&. #%ut leaves output and unemploment at their natural rates.
#ow the Phillips Curve is Related to the
$odel of Areate !emand and
Areate Supply+
1. An increase in the mone suppl increases aggregate demand#
 AD 2 
'. #and increases the in"ation rate#
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
&'pe(tations and the
Short-Run Phillips Curve
Expected inflation measures
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
&'pe(tations and the
Short-Run Phillips Curve
The ed&s ability to create unexpected
inflation exists only in the short run.
nce people anticipate inflation, the only
way to get unemployment below the natural
rate is for actual inflation to be above the
anticipated rate.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
&'pe(tations and the
Short-Run Phillips Curve
Unemployment Rate 3
!his euation relates the unemployment rate to the natural
rate o% unemployment* actual infation* an$ e5pecte$ infation
 
Short-Run Phillips Curve...
Inflation Rate
Short-run Phillips curve with high expected inflation
Short-run Phillips curve with low expected inflation
1. ()pansionar polic moves the econom up along the short-run Phillips curve...
$. #%ut in the long-run! e)pected in"ation rises! and the short-run Phillips curve shifts to the right.
 
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The /atural-Rate #ypothesis
returns to its natural rate, regardless of
the rate of inflation, is called the
natural-rate hypothesis.
 
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The /atural &'periment for the
/atural Rate #ypothesis
broke down in the in the early &/+s.
0uring the &/+s and &1+s, the economy
experienced high inflation and high
unemployment simultaneously.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Phillips Curve in the 012*s...
Unemployment Rate per(ent4
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0129
0122
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The rea:down of the Phillips Curve...
Unemployment Rate per(ent4
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0183
 
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Shifts in the Phillips Curve%
The Role of Supply Sho(:s
istorical events have shown that the
short-run %hillips curve can shift due to
changes in expectations.
 
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Shifts in the Phillips Curve%
The Role of Supply Sho(:s
The short-run %hillips curve also shifts
because of shocks to aggregate supply.
ajor adverse changes in aggregate supply
can worsen the short-run tradeoff between
unemployment and inflation.
and unemployment.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Shifts in the Phillips Curve%
The Role of Supply Sho(:s
' supply shock  is an event that directly
affects firms& costs of production and
thus the prices they charge.
$t shifts the economy&s aggregate
supply curve...
 
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 AS  2 
Supply...
'upply
1
A


&. #giving policma*ers a less favora%le tradeo+ %etween unemploment and in"ation.
PC  2
 
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Shifts in the Phillips Curve%
The Role of Supply Sho(:s
$n the ()/+s, policymakers faced two
choices when %E3 cut output and
raised worldwide prices of petroleum.
ight the unemployment battle by expanding
aggregate demand and accelerate inflation.
ight inflation by contracting aggregate
demand and endure even higher
unemployment.
 
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Inflation Rate per(ent per year4
Unemployment Rate per(ent4
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0185
018
7
0190
0182
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Cost of Redu(in Inflation
To reduce inflation, the ed has to pursue
contractionary monetary policy.
growth, it contracts aggregate demand.
This reduces the quantity of goods and
services that firms produce.
 
with high expected inflation
1. ,ontractionar polic moves the econom down along the short-run Phillips curve...
Unemployment Rate
Inflation
inflation
$. ... %ut in the long run! e)pected in"ation falls and the short-run Phillips curve shifts
!isinflationary $onetary Poli(y in the
Short Run and the )on Run...
 
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The Cost of Redu(in Inflation
To reduce inflation, an economy must
endure a period of high unemployment
and low output.
curve.
 
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The Cost of Redu(in Inflation
The sacrifice ratio is the number of
percentage points of annual output that
is lost in the process of reducing inflation
by one percentage point.
To reduce inflation from about (+5 in
()/)-()1( to 65 would have required an
estimated sacrifice of 7+5 of annual output8
 
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Rational &'pe(tations 
suggests that people optimally use all
the information they have, including
information about government policies,
when forecasting the future.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Rational &'pe(tations
tradeoff between inflation and
in the long run.
expectations adjust.
 
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Rational &'pe(tations 
suggests that the sacrifice-ratio could be
much smaller than estimated.
 
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The ;ol(:er !isinflation
9olcker succeeded in reducing inflation
:from (+5 to 65;, but at the cost of high
employment :about (+5 in ()17;.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Unemploymen Rate (percent
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The <reenspan &ra
began with a favorable supply shock.
$n ()1*, %E3 members abandoned their
agreement to restrict supply.
unemployment.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Unemployme Rate (percen
* 0 5 3 6 7 2 8 9 1 0**
5
6
2
9
0*
The <reenspan &ra...
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The <reenspan &ra
relatively small due to the ed&s actions.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Summary The %hillips curve describes a negative
relationship between inflation and
unemployment.
unemployment.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Summary
curve holds only in the short run.
The long-run %hillips curve is vertical at
the natural rate of unemployment.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Summary
'n adverse supply shock gives
policymakers a less favorable tradeoff
between inflation and unemployment.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Summary
money supply to reduce inflation, it
moves the economy along the short-run
%hillips curve.
unemployment.
quickly expectations of inflation fall.
 
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Summary
influence aggregate demand, the
instruments in an attempt to stabili>e the
economy.
government does not respond, the result is
undesirable and unnecessary
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
<raphical
@eview
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Phillips Curve...
Unemploymen t Rate
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
#ow the Phillips Curve is Related to the $odel
of Areate !emand and Areate Supply...
Phillips curve
Price evel
Low AD
High AD
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The )on-Run Phillips Curve...
Unemployme nt Rate
Phillips curve
B 1i/h
infation 1. When the Fed increases the growth rate of the mone suppl! the rate of in"ation increases#
$. # %ut unemplomen t remains at its natural rate in the long run.
Ao
$odel of Areate !emand and
Areate Supply+
Natural rate of unemployment
)on-run Phillips (urve
1  
(a) !he #o$el o% A//re/ate &eman$ an$ A//re/ate
'upply
&. #%ut leaves output and unemploment at their natural rates.
P  2 
1. An increase in the mone suppl increases aggregate demand#
 AD 2 
'. #and increases the in"ation rate#
 
Short-Run Phillips Curve...
Inflation Rate
Short-run Phillips curve with high expected inflation
Short-run Phillips curve with low expected inflation
1. ()pansionar polic moves the econom up along the short-run Phillips curve...
$. #%ut in the long-run! e)pected in"ation rises! and the short-run Phillips curve shifts to the right.
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Phillips Curve in the 012*s...
Unemployment Rate per(ent4
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0129
0122
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The rea:down of the Phillips Curve...
Unemployment Rate per(ent4
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0183
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Adverse Sho(: to Areate
Supply...
Quantity of   Output
'upply
1
A


&. #giving policma*ers a less favora%le tradeo+ %etween unemploment and in"ation.
PC  2
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Supply Sho(:s of the 018*s...
Inflation Rate per(ent per year4
Unemployment Rate per(ent4
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0185
018
7
0190
0182
with high expected inflation
1. ,ontractionar polic moves the econom down along the short-run Phillips curve...
Unemployment Rate
Inflation
inflation
$. ... %ut in the long run! e)pected in"ation falls and the short-run Phillips curve shifts
!isinflationary $onetary Poli(y in the
Short Run and the )on Run...
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The ;ol(:er !isinflation...
Unemploymen Rate (percent
* 0 5 3 6 7 2 8 9 1 0*
5
6
2
9
0*
0181
019*
0193
0190
0195
0196
0192
 
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The <reenspan &ra...
Unemployme Rate (percen
* 0 5 3 6 7 2 8 9 1 0**
5
6
2
9
0*
0196 0110
0197 0115
0113 0192