Short-run Policy Tradeoff

1
Short-run Policy Tradeoff

• Chapter 17

2
Short-run Phillips Curve

• A curve showing the relationship between the
  inflation rate and the unemployment rate in the
  short run
• Assuming the natural rate of unemployment and the
  expected inflation rate is unchanged.
• It shows tradeoff between inflation and
  unemployment (The lower inflation rate, the
  higher rate of unemployment).
• New Zealand economist Phillips discovered this
  relationship from the 100 years U.K. data in
  1958.

3
Short-run Phillips CurveContinued

• Okuns law
• For every percentage point that the unemployment
  rate is above the natural rate of unemployment,
  there is two percent gap between real GDP and
  potential GDP.
• The short-run Phillips curve is another way of
  presenting the AS curve.
• Shift of the short-run Phillips curve
• Caused by changes in the natural rate of
  unemployment or expected inflation rate.

4
Long-run Phillips Curve

• A vertical line the relationship between the
  inflation rate and the unemployment rate in the
  long run
• Assuming the economy is at full employment.
• It shows no tradeoff between inflation and
  unemployment.
• Any attempt to lower unemployment below the
  natural rate will only result in higher inflation
  without success in lowering unemployment in the
  long run.

5
Natural Rate Hypothesis

• The proposition that any change in unemployment
  due to money supply growth is only temporary and
  eventually the natural rate of unemployment
  prevails.
• Money supply growth ? expected inflation rate
  increase, and the short-run Phillips curve shifts
  up (or rightward).
• So, tradeoff along the short-run Phillips curve
  is temporary.
• No tradeoff along the long-run Phillips curve.

6
Natural Unemployment Rate

• Does it change? Yes.
• Increase in the 70s due to the baby boom
  generation entering the labor force and the oil
  crises.
• Decrease in the 80s and 90s due to the baby bust
  generation entering the labor force and
  technology innovation
• What happens to the Phillips curve?
• Both the short-run and long-run Phillips curves
  shift rightward.

7
Expected Inflation Rate

• What is it?
• The inflation rate that people forecast and use
  to set the money wage and other money price
• What determines it?
• Past inflation and the Feds monetary policy
• People have rational expectation
• Using all the relevant data and economic science
• What happens to the Phillips curve?
• Gradual shift of the short-run Phillips curve
• How to lower expected inflation?
• By lowering actual inflation rates over time.
• Surprise reduction vs. credible announced
  reduction