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Visit this website to read “The Federal Reserve Bank of Cleveland’s Economic Commentary: A New Approach to Gauging Inflation Expectations” by Joseph G. Haubrich for more information about how expected inflation is forecast.

The neoclassical phillips curve tradeoff

The Keynesian Perspective introduced the Phillips curve    and explained how it is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run. By contrast, a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment. [link] (a) shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, shown in [link] (b), is a vertical line, rising up from 5% unemployment, at any level of inflation. Read the following Work It Out feature for additional information on how to interpret inflation and unemployment rates.

From a long-run as curve to a long-run phillips curve

The graph shows three aggregate demand curves that all intersect with the vertical potential GDP line at 400 on the x-axis. Line AD0 intersects at (110, 400); line AD1 intersects at (115, 400); and line AD2 intersects at (120, 400).
(a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E 0 , E 1 , and E 2 , all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%.

Tracking inflation and unemployment rates

Suppose that you have collected data for years on the rates of inflation and unemployment and recorded them in a table, such as [link] . How do you interpret that information?

Year Inflation Rate Unemployment Rate
1970 2% 4%
1975 3% 3%
1980 2% 4%
1985 1% 6%
1990 1% 4%
1995 4% 2%
2000 5% 4%

Step 1. Plot the data points in a graph with inflation rate on the vertical axis and unemployment rate on the horizontal axis. Your graph will appear similar to [link] .

Inflation rates

This graph shows several points of intersection between unemployment rates and inflation rates, one point for each year. Horizontal dashed lines extend from the y-axis at 5%, 4%, 3%, 2%, 1% and 5%. Vertical dashed lines extend from the x-axis at 2%, 3%, 4%, 6% and 4%. The points of intersection between these various lines are (2, 3); (3, 3), (4, 1); (4, 2); (4, 5); (6, 1); (5, 4).

Step 2. What patterns do you see in the data? You should notice that there are years when unemployment falls but inflation rises, and other years where unemployment rises and inflation falls.

Step 3. Can you determine the natural rate of unemployment from the data or from the graph? As you analyze the graph, it appears that the natural rate of unemployment lies at 4%; this is the rate that the economy appears to adjust back to after an apparent change in the economy. For example, in 1975 the economy appeared to have an increase in aggregate demand; the unemployment rate fell to 3% but inflation increased from 2% to 3%. By 1980, the economy had adjusted back to 4% unemployment and the inflation rate had returned to 2%. In 1985, the economy looks to have suffered a recession as unemployment rose to 6% and inflation fell to 1%. This would be consistent with a decrease in aggregate demand. By 1990, the economy recovered back to 4% unemployment, but at a lower inflation rate of 1%. In 1995 the economy again rebounded and unemployment fell to 2%, but inflation increased to 4%, which is consistent with a large increase in aggregate demand. The economy adjusted back to 4% unemployment but at a higher rate of inflation of 5%. Then in 2000, both unemployment and inflation increased to 5% and 4%, respectively.

Step 4. Do you see the Phillips curve(s) in the data? If we trace the downward sloping trend of data points, we could see a short-run Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates. If we trace the vertical line of data points, we could see a long-run Phillips curve at the 4% natural rate of unemployment.

Questions & Answers

what are the side effects of government policies
narayan Reply
Government policy can influence interest rates, a rise in which increases the cost of borrowing in the business community. Higher rates also lead to decreased consumer spending. Lower interest rates attract investment as businesses increase production.
if there is a negative technology shock to the economy in short run the firms production cost will go up and labor goes down and thus consumption and production will be lower than before. the government can spend to create jobs and central Bank can lower the interest rates
what are marlet prices
Jaheim Reply
price which includes net indirect taxes
what is aggregate demand
Kalkidan Reply
what is micro economics
A-dip Reply
microscopic study...
microeconomics is study of individual, household and firms of division making and allocation of resources.
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what a pure economics. must have downloaded by mistake.
microeconomics is the study of an individual unit in an economic system or an household
what really cause inflation?
Urey Reply
what is trade deficit
vivek Reply
is ther forgon alternative. is the amount sacrifice of one thing to gain another thing
what is enflation rate?
Mohibullah Reply
Is it inflation rate sir
This is the annual rate of increase of basic household goods and services and measures also the cost of living and doing business in a country. it's a important information when making for forecast or business plans.
this is continuous increase of overall price level
the betewen microeconomics and macroeconomics is microeconomics is concerned with individual scarcity like household,workers and so on while macroeconomics is focuced on the problème winth organisation the collaboration with others companies the profits and then the growth of the organisation
Amadou Reply
what is tax base
ekwuye Reply
The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority.
what is economic system
Alinda Reply
Quantity of Gasoline in millions was?
Touseef Reply
1000cubic meter
definition of phillips curve
Alok Reply
what is closed economy
Nati Reply
an economy that is not open
meaning: The economy is a closed system, there is not trade between this economy and another one, so no shared market. just a system with no outside influences.
what are the decision-making unit of an economy..?
an economy which is not involved in exchange with foreign countries
what is the demand curve
Cabdiqani Reply
it is the graph of aggregate demand in a market
the demand curve is a graph showing the quantity demand and price and the numbers and numbers of units at various quantity demanded
' it is a diagram with two axes one represent price, the other represents quantity demanded. the curve slops downwords from left to right interpreting the Law of demand (reversed proportion between price and demand ) The higher the price the lower the demand..
What is DMU and how affects demand?
what is the correlation between poverty inequality and crime
What is economic growth
An increase in the production of goods and services.
economic growth is the quantative approach , in which the GDP of nation is increase..
poverty and inequality is a direct result of the unequal distribution of wealth. Crime is directly related to poverty and inequality, if a minority of a population control the resources and wealth of a nation, the majority will tend to illegal activities to gain resources to sustain their demand.
what is enflation rate?

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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