Short Run Phillips Curve. When the economy is overheating, there is low unemployment but high inflation

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2 Inflation and Unemployment-The Inverse Relationship / Negative Correlation (cont.) The short-run (SR) Phillips curve shows the tradeoffbetween inflation and unemployment. What happens to inflation and unemployment when AD increase? Notice that the higher the inflation rate, the lower the unemployment rate is. This occurs because inflation occurs when the economy is in overdrive; when real GDP is above potential GDP and rising. As firms produce to meet the increased demand, more labor is needed. Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation / Page 2 50/0 When there is a recession, unemployment is high but inflation is low I /.... / 0. SRPC 2 /o 9 /o U nemployment

3 Inflation and Unemployment-The Inverse Relationship / Negative Correlation (cont.) In general, there is an inverse relationship between unemployment and inflation.. C: ~ 4 +-~~~~~~~--=-~~ ~~~~~~--~... t - Unemplo, r en.. ra e (~~),- In -,a Jon rate (~S) Page 3

4 Please do this: 1. What does the SRPC show? Macroeconomics Do-Now 2. Draw the SRPC and include some examples (dots). 3. What does P = MB mean? Explain. 4. Define and create an example for consumer surplus? Page 4

5 Macroeconomics Do-Now 1. the inverse relationship between the inflation rate and unemployment and its overall impact on real GDP (f) 2. Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation So/o.... When there is a recession, unemployment is high but inflation is low Page SRPC Unemolo vment

6 Macroeconomics Do-Now 3. the price of an item sold should always be at least equal to the marginal benefit people are receiving from it 4. the difference between your willingness to pay for an item (say $16 for a movie), and the price you actually paid for it ($8) Page 6

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14 Demand and Price Shocks Shifts in the aggregate demand (AD) curve, (when anything besides inflation alters AD)~ are called demand shocks. Changes in government purchases and the shifts in monetary policy are examples of demand shocks. A positive demand shock increases demand (D) while a negative one decreases demand. Shifts in the inflation adjustment (IA) line, and thus a shift in potential GDP, are called supply shocks or price shocks. Supply or price shocks usually occur when a temporary shortage of a key commodity, or a group of commodities, drives up prices by such a large amount that it has a noticeable effect on the rate of inflation. Oil prices are a very noticeable price/supply shock. Such shocks move real GDP ( Y) significantly, though temporarily, away from potential GDP, but always end up back at the baseline where it started. A positive supply shock increases supply, a negative decreases supply. Page 14

15 Macroeconomics Do-Now Please do this: 1. Draw the SRPC and include some examples (dots). 2. Draw the SRPC indicating an increase in AS ( expansion/inflation). 3. Draw an AS/ AD and a PC curves side by side showing a decrease in AS. ( contraction/recession). 4. Draw the LRPC. Why is it vertical? What does a pint on its cruve indicate? (think of LRAS) 5. Contrast fixed factor and variable factor? Page 15

16 Macroeconomics Do-Now 1. TheS.RPC When the economy is overheating, there is low unemployment but high inflation Inflation Page When there is a recession, unemployment is high but. inflation is low : I 1 10 SRPC Unemployment

17 Macroeconomics Do-Now 2~ nfta on ~hi!n ds falls 1,, l Page 17

18 Macroeconomics Do-Now 3. :Wh n ds falls Price LRAS Inflation Level...,. Page 18 Q AD GDPa u Unemployment SRPC 1 : SRPC

19 Macroeconomics Do-Now 4. The LRPC In the long run there is no tradeoff between inflation and unemployment Inflation Long Run Phillips Curve 5o/o 3o/o The LRPC is vertical at the atural Rate of Unemployment 1 o/o Page 19 2 /o 5 /o 9 /o Unemployment _

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24 The Phillips Curve-Questions Assume that the United States economy is currently jn a shott-run equjljbrium with the actual unemployment rate above the natural rate of unemployment. (a) Draw a single correctly labeled graph with both the long-run Phillips curve and short-run Phillips curve. Label the current short-tun equj]ibtium point P. (b) Assuming no policy actions are taken, will the short-tun PhilJjps curve shift to the right (upward) shift to the left (downward), or remain the same in the long tun? Explain. (c) If the Federal Reserve Bank wants to lower unemployment, what expansionary open-market operation should it u e? (d) How will the open-market operation you identified in patt (c) affect each of the following? (i) Federal funds rate. Explain. (ii) Real interest rate in the short tun. (e) Given your answer in pa1 (d)(ii), what is the effect on real gross domestic product (GDP) in the short run? Explain. (f) Japan and the United States are major trading partners. Indicate how the change in real GDP you identified in part (e) will affect the demand for the Japanese yen in the foreign exchange market. (g) Draw a cortectly labeled graph of the foreign exchange market for the Japanese yen showing the effect of the change in de1nand identified in part (f) on the value of the Japanese yen relative to the United States dollar. Page 31

25 The Phillips Curve-Questions 10 poin ts ( } LRPC (a) 2 points : One point is earned for drawing a correctly labeled graph showing a vertical LRPC and a downward sloping SRPC. One point is earned for showing point P on the SRPC to the right of LRPC. Page 32 SRPC UNEMPLOYMENT RATE ('ff) (b) 1 point: One point is earned for stat ing that SRPC will shift t.o the left, and for explaining that producing at a level of output below full emp loyment will creat e higher unempl oyment and lower inflationary expectations that will result in lower nominal wages and input costs. (c) 1 point: One point is earned for stat ing that the Federal Reserve should buy bonds. (d) 2 points : One point is earned for stating that the federal funds rate will decrease and for explaining that the money supply will increase, which will increase rese.rves and decrease the fooeral funds rate. One point is gamed for stating that the real interest rate will decrease in the short run.

26 The Phillips Curve-Questions (e) 1 point: One point is earned for stating that real GDP will increase in the short run and for explaining that a decrease in the real int.ere.st rate will increase interest-sensitive spending, which includes consumption and investment in plant and equipment, riesulting in an increase in aggregate demand. (t) 1 point : One point is earned for stating that the demand for the Japanese yen will increase in the foreign exchange market. (g) 2 points: One point is earned for drawing a correctly labeled graph of the foreign exchange market for the Japanese yen. One point is earned for showing a rightward shift of the demand curve for the yen and showing an increase in the dollar price of the yen (appreciating yen). Page 33

27 The Phillips Curve-Questions Assume that the Unit ed States eco nomy is opera ting below full employment. (a) Draw a correctly labe led graph of long-run agg rega te supply, short-run agg regate supply, and agg regate demand, and show eac h of the fo llow ing. (i) Current equilibrium output and price leve l, labejed as Y 1 and PL 1 (ii) Ful I-employment output, labe led as Y f (b) Assume that the Federa J Reserve targe ts a new fede ral funds rate to reach fujj employment. Should the FederaJ Reserve target a higher or lowe r federal fund s rate? (c) Given the Fede ral Rese rve action you identified in part (b), dr aw a correctjy JabeJed grap h of the money market and show the effect on the nominal interest rate. ( d) Assume the gove rnment Jowe rs income tax rates to elimin ate the recess ionary gap. Will each of the fojjowing increase, decrease, or stay the same? (i) Aggregate demand. Exp lain. (ii) Long-run aggrega te supply. Explain. Page 34

28 The Phillips Curve-Questions 7 points ( ) LRAS SRAS REA L GD P (a) 2 points : One point is earned for drawing a co rrectly labeled graph showing AD, SRAS, Y, and PL.. One point is earned. for drawing a vertical I.RAS at Y1 to the right of Y,. (b) 1 point: One point is earned. for stating that the Federal Reserve should target a lower federal funds rate. M I M S 1 MD M M.., QUANT ITY OF M ONEY Page 35 (c) 2 points : One point is earned. for drawing a correctly labeled money market graph. One poi nt is earned for shifting the money supply curve t o the right and showing a decrease in the n o minal inter est rate.

29 The Phillips Curve-Questions ( d) Assume the government Jowe rs income tax rates to elimin ate the recess ionary gap. Will each of the fojjowing increase decrease, or stay the srune? (i) Aggregate demand. Explain. (ii ) Long-run aggrega te supply. Explain. Page 36

30 The Phillips Curve-Questions Infl ation and expec ted inflation are impo t1ant determin a nts of eco nomic activity. (a) Dr aw a co rrectly labeled graph of a short-run PhiJJips curve. (b) Usjng your graph in p art (a), show the effec t of an increase in the expected rate of jnflation. (c) What is the effec t of the increase in the expected rate of jnfl ation on the long-run PhjlJip s curve? (d) Given the increase jn the expec ted rate of inflation frorn part (b), (j) wijj the nomina l interest rate on new loa n inc rease, decrea e, or re main unc hanged? (jj) will the real interest rate on new loans jncrease, decrease, or remain unchanged? (e) Assume that the nominaj interest rate is 8 percent. Borrowers and lenders expect the rate of inflation to be 3 percent, and the grow th rate of real gross domestic product is 4 perce nt. Calc ulate the real jnterest rate. Page 37

31 The Phillips Curve-Questions 6 point s ( ) ~ SRPC SRPC' UNEMPLOYMENT RATE( %) (a) 1 point: (b) 1 point: One point is earned for drawing a correctly labeled graph of the short-run Phillips curve. One point is earned for shifting the short-run Phillips curve to the right. (c) 1 point : One point is earned for stating that the increase in expected inflation does not affect the longrun Phillips curve. (d) 2 points: One point is earned for stating that the nominal interest rate will increase. One point is earned for st.a ting that the real interest rate will remain unchanged. Page 38