Chapter 15 Study Notes

The Short-Run Policy Tradeoff

Introduction

This chapter explores the short-run tradeoff between inflation and unemployment, focusing on the Phillips Curve, Okun’s Law, and the effects of monetary policy on expected inflation. These concepts are central to understanding macroeconomic policy decisions and their impact on the economy.

The Phillips Curve

The Short-Run Phillips Curve (SRPC)

The Short-Run Phillips Curve illustrates the inverse relationship between the inflation rate and the unemployment rate, assuming the natural unemployment rate and expected inflation rate remain constant.

• Definition: The SRPC shows how, in the short run, lower unemployment is associated with higher inflation, and vice versa.

• Key Point: The curve is downward sloping, reflecting the tradeoff between inflation and unemployment.

• Example: If unemployment falls from 7% to 2%, inflation may rise from 3% to 9% (see diagram below).

Diagram: The SRPC is typically plotted with inflation rate on the vertical axis and unemployment rate on the horizontal axis.

Phillips Curve Analysis

• Points on the Curve: Each point represents a possible combination of inflation and unemployment rates.

• Anchor Point: The natural unemployment rate and expected inflation rate determine the position of the SRPC.

Okun’s Law

Definition and Application

Okun’s Law describes the relationship between unemployment and real GDP. It quantifies how changes in unemployment affect the output of the economy.

• At the natural unemployment rate: Real GDP equals potential GDP.

• If unemployment is below the natural rate: Real GDP exceeds potential GDP.

• If unemployment is above the natural rate: Real GDP is less than potential GDP.

Formula:

$\text{For each percentage point that the unemployment rate is above the natural rate, real GDP is 2\% below potential GDP}$

Okun’s Law Table

Unemployment Rate (%)	Real GDP (Trillions of $)
5	10.2
6	10.0
7	9.8

Additional info: This table demonstrates the quantitative impact of rising unemployment on real GDP.

Phillips Curve and Aggregate Supply

Relationship Between SRPC and Aggregate Supply Curve

The SRPC and the Aggregate Supply (AS) curve are related through their depiction of short-run economic fluctuations.

• SRPC: Shows the tradeoff between inflation and unemployment.

• AS Curve: Shows the relationship between the price level and real GDP.

• Correspondence: Points on the SRPC correspond to points on the AS curve, linking inflation/unemployment to price level/output.

Short-Run and Long-Run Phillips Curve

Long-Run Phillips Curve (LRPC)

The Long-Run Phillips Curve is a vertical line at the natural rate of unemployment, indicating no tradeoff between inflation and unemployment in the long run.

• Definition: The LRPC shows that, regardless of the inflation rate, unemployment will settle at its natural rate in the long run.

• Implication: Policy can only affect unemployment temporarily; in the long run, only inflation changes.

Diagram: The LRPC is vertical at $u_n$ (natural unemployment rate).

No Long-Run Tradeoff

• Key Point: The tradeoff between inflation and unemployment exists only in the short run.

• Long-Run Outcome: The economy returns to the natural rate of unemployment, regardless of inflation.

The Natural Rate Hypothesis

Definition and Dynamics

The Natural Rate Hypothesis states that changes in inflation affect unemployment only temporarily; eventually, unemployment returns to its natural rate.

• Short-Run: An increase in inflation reduces unemployment (movement along SRPC).

• Long-Run: Expectations adjust, shifting the SRPC, and unemployment returns to the natural rate.

Diagram: Shows SRPC shifting as expected inflation changes.

Changes in Natural Unemployment Rate

• Shifts in LRPC: If the natural unemployment rate changes, the LRPC shifts horizontally.

• SRPC Adjustment: The SRPC also shifts to reflect new expectations and wage-setting behavior.

Expected Inflation Rate

Role and Adjustment

The expected inflation rate is the rate that people forecast and use to set wages and prices. Changes in expected inflation shift the SRPC.

• SRPC Shifts: When expected inflation rises, the SRPC shifts upward; when it falls, the SRPC shifts downward.

• Intersection: The SRPC always intersects the LRPC at the expected inflation rate.

Influencing the Expected Inflation Rate

• Rational Expectations: The expected inflation rate is determined by all available data and economic theory.

• Policy Implication: Central banks can influence expectations through credible announcements and actions.

Monetary Policy and Inflation Reduction

Fed’s Actions to Reduce Unemployment

The Federal Reserve (Fed) can attempt to lower the inflation rate through two main approaches:

• 1. Surprise Inflation Reduction: The Fed raises interest rates and slows money growth without prior announcement.

• 2. Credible Announced Inflation Reduction: The Fed announces its intention to reduce inflation before acting.

A Surprise Inflation Reduction

• Mechanism: Higher interest rates and slower money growth reduce aggregate demand.

• Short-Run Effect: Unemployment rises, inflation falls, and expected inflation gradually decreases.

• Drawback: May cause temporary loss of output and higher unemployment.

A Credible Announced Inflation Reduction

• Mechanism: The Fed announces its policy, influencing expectations before taking action.

• Effect: Aggregate demand falls in anticipation, inflation and expected inflation decline, and wage growth slows.

• Advantage: Inflation is reduced without increasing unemployment or reducing output.

Summary Table: Phillips Curve Concepts

Concept	Short-Run	Long-Run
Phillips Curve	Downward sloping (tradeoff)	Vertical (no tradeoff)
Unemployment	Can be below/above natural rate	Returns to natural rate
Inflation	Varies with unemployment	Can be any rate

Additional info: These concepts are foundational for understanding how monetary policy affects inflation and unemployment, and why expectations play a crucial role in macroeconomic outcomes.