Chapter 16 Inflation and Unemployment

1. Chapter 16 Inflation and Unemployment

2. 1. THE ROLE AND NATURE OF INVESTMENT Learning Objectives • Draw a Phillips curve and describe the relationship between inflation and unemployment that it expresses. • Describe the other relationships or phases that have been observed between inflation and unemployment.

3. 1.1 The Phillips Curve • The Phillips curve is a curve that suggests a negative relationship between inflation and unemployment.

4. 1.2 The Phillips Curve Goes Awry The Phillips Curve in the 1960’s (U.S.)

5. 1.2 The Phillips Curve Goes Awry When considering Unemployment and Inflation (U.S.) from 1961-2008 the data does not appear consistent with the theory behind the Phillips curve!

6. 1.3 Cycles of Inflation and Unemployment Unemployment and Inflation (U.S.) 1961-2002 Sequential connections suggest a clockwise cyclical pattern

7. 1.3 Cycles of Inflation and Unemployment • The Phillips phase is the period in which inflation rises as unemployment falls. • The stagflation phase is the period in which inflation remains high while unemployment increases. • The recovery phase is a the period in which inflation and unemployment both decline. • The Inflation-unemployment cycle is a pattern consisting of a Phillips phase, followed by stagflation, and then a recovery.

8. 1.3 Cycles of Inflation and Unemployment Phases of the Inflation-Unemployment cycle

9. 2. EXPLAINING INFLATION-UNEMPLOYMENT RELATIONSHIPS Learning Objectives • Use the model of aggregate demand and aggregate supply to explain a Phillips phase, a stagflation phase, and a recovery phase.

10. 2.1 The Phillips Phase: Increasing Aggregate Demand LRAS 3 SRAS1,2,3 3 2 AD3 Phillips phase 1 2 1 AD2 AD1

11. 2.1 The Phillips Phase: Increasing Aggregate Demand The relationship between GDP and unemployment from the previous slide.

12. 2.2 Changes in Expectations and the Stagflation Phase LRAS 4 SRAS4 4 Stagflation phase 3 SRAS1,2,3 3 2 AD3,4 Phillips phase 1 2 1

13. 2.3 The Recovery Phase 4 5 LRAS AD5 SRAS4 4 Stagflation phase 3 SRAS1,2,3 3 Recovery phase 5 AD3,4 2 Phillips phase 1 2 1 AD2 AD1

14. 3. INFLATION AND UNEMPLOYMENT IN THE LONG RUN Learning Objectives • Use the equation of exchange to explain what determines the inflation rate in the long run. • Explain why in the long run the Phillips curve is vertical. • Describe frictional and structural unemployment and the factors that may affect these two types of unemployment. • Describe efficiency wage theory and its predictions concerning cyclical unemployment.

15. 3.1 The Inflation Rate in the Long Run EQUATION 3.1 EQUATION 3.2 EQUATION 3.3 • Inflation rates and economic growth

16. 3.1 The Inflation Rate in the Long Run

17. 3.2 Unemployment in the Long Run

18. 3.2 Unemployment in the Long Run • Frictional unemployment • A reservation wage is the lowest wage that an unemployed worker would accept, if it were offered.

19. Public Policy and Frictional Unemployment Programs that provide labor market information tend to shift the BOR cures of individual workers to the left, reducing the duration of the job search and unemployment, and increasing the wage. Unemployment compensation tends to increase the duration over which a worker will hold out for a higher wage, shifting the RW curve to the right, increasing unemployment and the wage. BOR2 BOR1 BOR1 W0 W0 W2 W2 W1 W1 RW2 RW1 RW1 t2 t0 t0 t1 t1 t2

20. 3.2 Unemployment in the Long Run • Structural unemployment • Cyclical unemployment and efficiency wages • Efficiency wage theory is based on the idea that firms may hold to a real wage greater than the equilibrium wage.