The Short-Run Phillips Curve

• In 1958, New Zealand-born economist Alban W.H. Phillips found that when the unemployment rate was high, wage rates tended to fall

• Conversely, when the unemployment rate was low, wage rates tended to rise

• Using data in the 1950s and the 1960s, the simple negative relationship between inflation and unemployment generally held true

• Graph

  

Inflation Expectations

• Changes in expected inflation will affect the Short-Run Phillips Curve (SRPC)

• An increase in expected inflation shifts the short-run Phillips curve upward

• People will tend to base their expectations of inflation based on their experiences

• When people were accustomed to low inflation rates, the correctly reasoned (at the time) that future inflation rates would also be low

Inflation and Unemployment in the Long Run

• Most economists believe that in the long-run, there is no trade-off between unemployment and inflation

• To avoid accelerating inflation overtime, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation

• The unemployment rate at which inflation does not change over time is known as the nonaccelerating inflation rate of unemployment, or NAIRU

• The Long-Run Phillips Curve (LRPC) is the relationship between unemployment and inflation after expectations of unemployment have had time to adjust over time

• Graph

  

The Costs of Disinflation

• Generally, politicians and economists have found that bringing inflation down is much harder than increasing it

• In the early 1980s, the United States used contractionary policies which brought about disinflation

• Policy makers reasoned that the long-term benefit of controlling double-digit inflation was worth the short-term pain that totaled an equivalent of nearly $2.6 trillion (2010 dollars)

• A clear policy of announcing of policy of disinflation, some economists argue, helped in easing the pain

The Costs of Deflation

• Deflation is the fall in the aggregate price level, which was a common occurrence before World War II in the United States

• After WWII, inflation became the norm. But, in the 1990s, deflation reemerged in Japan

• Why is deflation bad? Aren't lower prices good?

• In deflation, lenders gain and borrowers lose since a dollar has more purchasing power in the future

• The effect of deflation, ultimately, leads to a reduction of aggregate demand which, many economists will argue, played a significant role in the Great Depression

Practice Questions

• An increase in expected inflation will do which of the following?

  a. Shift the SRPC downward

  b. Shift the SRPC upward

  c. Shift the LRPC upward

  d. Shift the LRPC downward

  e. None of the above

  Answer: b

• Draw a correctly labeled graph showing a SRPC with an inflation rate of 2% and the NAIRU at 5%

  

• Assume an economy is in a recession. Draw a correctly labeled graph showing the following (SRPC, LRPC, and point A, which represents the current state of recession)