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.