Chapter 35

Chapter 35 explains the tradeoff relationship between unemployment and inflation in the short run. Phillips was the British economist that concluded that inflation and unemployment were linked. The Phillips Curve shows a negative relationship between unemployment and inflation. In the short run, a higher unemployment rate has a lower inflation rate. The Phillips curve basically demonstrates the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate demand curve move the economy along the short run aggregate supply curve. In the long run, the Phillips Curve is vertical, showing that the natural rate of unemployment is unchanged by different inflation rate levels. The vertical long run Phillips curve shows the classical idea of monetary neutrality. An increase in the money supply increases aggregate demand, raises the price level, and increases the inflation rate, but leaving output and unemployment at their natural rates. Friedman and Phelps introduced a new variable to the inflation-unemployment relationship: expected inflation. Expected inflation measures how much people expect the overall price level to change. Freidman and Phelps' work can be summarized into the equation: Unemployment rate= natural rate of unemployment-a(actual inflation-expected inflation). The natural rate hypothesis is that unemployment eventually returns to its natural rate, regardless of the rate of inflation. Stagflation is the combination of rising prices and falling output. The short-run Phillips Curve shifts due to supply shocks to aggregate supply. An adverse shift in aggregate supply lowers output and raises the price level. This gives policymakers a less favorable tradeoff between unemployment and inflation. Contradictory policy moves the economy down along the short run Phillips curve but in the long run expected inflation falls and the short run Phillips curve shifts to the left. The Volcker Disinflation shows how Volcker was successful at reducing inflation, but at a cost of having a high unemployment rate.

Chapter 34

Chapter 34 is about monetary and fiscal policy and their effects on the aggregate demand curve. Out of the three reasons that the aggregate demand is downward sloping, the interest-rate effect is the most important reason. The interest rate effect, as explained in the previous chapter, is that a lower price level reduces the amount of money people want to hold. The theory of liquidity preference is that the interest rate adjusts to the money supply and money demand's equilibrium. The two pieces of the theory of liquidity preference is money supply and money demand. Money supply is controlled by the Federal Reserve, who then alters the supply with the buying and selling of government bonds in open market operations. When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any price level, shifting the aggregate demand curve right. The inverse situation of this is also true. Fiscal policy is the determining of the level of government spending and taxation by policymakers. The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income, which then increases consumer spending. The marginal propensity to consume (MPC) is the fraction of extra income that a household consumes rather than saves. The Multiplier equation is Multiplier=1+MPC+MPC^2+MPC^3... When x=MPC then the equation can be simplified to Multiplier= 1/(1-MPC). The larger the MPC, the greater effect on consumption, and the larger the multiplier. The crowding out effect is when expansionary fiscal policy raises the interest rate, which then reduces investment spending, creating a reduction in aggregate demand. Economic stabilization has been a clear goal of the United States policy since the Employment Act of 1946.  

Chapter 33

Chapter 33 is about analyzing short-run fluctuations with aggregate demand and aggregate supply curves. Economic fluctuations are irregular and unpredictable. Most macroeconomic quantities fluctuate together. Real GDP and investment spending have a direct relationship. As real GDP rises, investment spending rises. However, as real GDP rises, unemployment falls. They therefore have an inverse relationship. Most economics believe that classical theory describes the world in the long run but not in the short run. The aggregate demand curve is downward sloping while the short-run aggregate supply curve is upward sloping. The aggregate demand curve is downward sloping because wealthier consumers demand more consumption of goods, interest rates falling increases investment demand, and the depreciation of currency causes more demand of net exports. The aggregate demand curve might shift from changes in consumption, changes in investment, changes in government purchases, and changes in net exports. The long run aggregate supply curve is vertical because a change in the price level does not affect the quantity of goods and services supplied in the long run. The long run aggregate supply curve might shift from changes in labor, changes in capital, changes in natural resources, and changes in technological knowledge. The sticky-wage theory says wages are "sticky" in the short run, meaning that nominal wages are slow to adapt to new economic changes. The sticky-price theory says that prices of some goods are slow to adapt to new economic conditions. Stagflation is the economy experiencing both stagnation (falling output) and inflation (rising prices). Shifts in the aggregate supply can cause stagflation. Policymakers who can influence aggregate demand can potentially reduce the adverse impact on output but only at the cost of worsening the problem of inflation.