Illustrate the effects of the following developments on both...

Key Concepts

Phillips Curve

The Phillips curve represents the inverse relationship between unemployment and inflation, suggesting that lower unemployment is associated with higher inflation in the short run. It illustrates the trade-offs policymakers face when trying to stabilize both inflation and unemployment, but its validity and shape depend on underlying economic assumptions, particularly regarding inflation expectations and the behavior of firms and workers.

Short-run Phillips Curve

The short-run Phillips curve reflects a temporary trade-off between unemployment and inflation when expectations remain fixed or adjust slowly. In the short run, various shocks such as changes in government spending, oil prices, or inflation expectations can shift the curve, resulting in deviations from the long-run equilibrium. The curve’s position changes in response to supply and demand disturbances even though the underlying natural rate of unemployment remains constant.

Long-run Phillips Curve

The long-run Phillips curve is vertical at the natural rate of unemployment, indicating that in the long run, there is no trade-off between inflation and unemployment. Regardless of the level of inflation, the economy tends to return to its natural rate of unemployment once inflation expectations are fully adjusted. This concept underscores the idea that any attempt to maintain unemployment below its natural rate through expansionary policies will only lead to accelerating inflation.

Natural Rate of Unemployment

The natural rate of unemployment is the level of unemployment that prevails when the economy is in long-run equilibrium, incorporating frictional and structural unemployment but not cyclical fluctuations. Changes in the natural rate, such as those caused by shifts in labor market institutions or demographics, directly affect the long-run Phillips curve by determining its vertical position and, in the short run, the overall inflation-unemployment dynamics.

Inflation Expectations

Inflation expectations are the forecasts that households and firms have regarding future inflation. They play a critical role in the formation of wage contracts and price-setting behavior, thereby influencing the short-run trade-off between unemployment and inflation. Changes in expected inflation can shift the short-run Phillips curve without affecting the long-run relationship, as only unanticipated inflation affects real economic activity in the short run.

Aggregate Demand and Fiscal Policy Effects

Aggregate demand, influenced by fiscal policy such as government spending, affects the economy’s output and employment in the short run. An increase in government spending can stimulate demand, temporarily lowering unemployment and pushing up inflation, resulting in a movement along or a shift of the short-run Phillips curve. However, with sustained changes, inflation expectations adjust and the long-run relationship, as depicted by the vertical Phillips curve, remains anchored at the natural rate of unemployment.

Supply Shocks

Supply shocks, such as a decline in the price of imported oil, affect production costs and can lead to shifts in the short-run Phillips curve. A positive supply shock reduces production costs, thereby lowering the inflation rate for any given level of unemployment, which results in a downward shift of the short-run Phillips curve. Nonetheless, if the natural rate of unemployment remains unchanged, the long-run Phillips curve will not be affected by such supply-side fluctuations.

Transcript

00:01 All right, moving on with question two in chapter 35.

00:05 We need to illustrate the effects of the following developments on both the short -run and long -run phillips curves.

00:10 We also need to give the economic reasoning underlying our answers.

00:15 All right, before we begin, we need to make sure that every time we're being asked to identify development or to evaluate the impact of something, we need to know whether this shock that hits the economy is a supply.

00:30 Shock, an aggregate supply shock, an aggregate demand shock, or structural shock.

00:35 And after that, we need to see which part of the economy affects and towards what way.

00:40 Right.

00:41 So, part day says arise in the natural rate of unemployment.

00:45 So let's think about it.

00:47 An increase in the natural rate of unemployment means that this is a structural change, structural shock.

00:54 For whatever level of inflation, the unemployment will be higher.

00:57 And it will be permanently higher because in the long run, it will gravitate towards a higher level of employment.

01:05 So the first thing we know is that the long run phillips curve right here on the left will shift from lrpc1, lrpc2 will shift to the right.

01:14 That's one thing that we know for sure.

01:16 So now it intersects with the x -axis at a higher point, u -star prime.

01:22 The other thing that we also know is that this is apart from a structural shock, this is also a supply shock, right? if there is a permanent increase in natural rate of unemployment, this means that for whatever inflation rate, we have less labor force participation, right? so there is a shock to the supply of labor, one of the factors of production.

01:49 So the second development is that the short -run phillips curve will also increase from srpc1, srpc2 to the right.

01:57 And this also means that this is also a necessary increase.

02:03 Because we need, the question doesn't say anything about inflation.

02:06 So inflation, we assume it stays the same.

02:09 So we need the phillips curve to go up in order to dissect the new long run phillips curve at the same point.

02:17 Pi e.

02:19 All right.

02:20 Part b, we're dealing with a decline in the price of imported oil...