Matt Telker Mr. Beler AP Macroeconomics 04.23.

12 Chapter 35: The Short-Run Trade-Off between Inflation and Unemployment I. The Phillips Curve A. a curve that shows the short-run trade-off between inflation and unemployment B. Aggregate Demand, Aggregate Supply, and the Phillips Curve 1. The Phillips curve simply shows the combination 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 2. An increase in aggregate demand for goods and services leads to a larger output of goods and services and a higher price level. Larger output means greater employment and, thus, a lower rate of employment 3. The higher the price level in the current year, the higher the rate of inflation 4. Monetary and fiscal policy can move an economy along the Phillips curve Shifts in the Phillips Curve: The Role of Expectations A. The Long-Run Phillips Curve 1. Classical theory points to growth in the money supply as the primary determinant of inflation, but classical theory also states that monetary growth does not affect real variables such as output and employment. a. Long run curve is vertical, unemployment will always gravitate back to its normal rate 2. The vertical curve is an expression of the classical idea of monetary neutrality B. The Meaning of Natural 1. Natural rate of unemployment is not necessarily the socially desirable rate of unemployment, nor is it constant over time 2. New union uses market power to raise real wages. This results in excess worker supply, higher natural rate of unemployment 3. To reduce natural rate of unemployment, policymakers should look to policies that improve the functioning of the labor market C. The Short-Run Phillips Curve 1. Unemployment Rate = Natural rate of unemployment a(actual inflation expected inflation) Shifts in the Phillips Curve: The Role of Supply Shocks A. Supply shock an event that directly alters firms costs and prices, shifting the economys aggregate-supply curve and thus the Phillips curve 1. Oil price increase B. Combination of rising prices and falling output is called stagflation

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The Cost of Reducing Inflation A. The Sacrifice Ratio 1. the number of percentage points of annual output lost in the process of reducing inflation by one percentage point 2. A typical estimate is 5 a. For each percentage point that inflation is reduced, 5 percent of annual output must be sacrificed B. Rational Expectations and the Possibility of Costless Disinflation 1. Rational expectations the theory according to which people optimally use all the information they have, including information about government policies, when forecasting the future 2. according to those rational-expectation theorists, sacrifice ration estimates were unreliable guides since people take their expectations of inflation into account when policies change