Inflation and Unemployment Read chapter 16 – pages 330-346.

1. Inflation and Unemployment Read chapter 16 – pages 330-346. I Relating Inflation and Unemployment • The Phillips curve is a curve that suggests a negative relationship between inflation and unemployment. B) Historically, the Phillips curve seemed to work all right during the 1960’s, but has been less stable during more recent years.

5. C) The cycle of inflation and unemployment • The Phillips phase is a phase in which inflation rises as unemployment falls. • The stagflation phase is a phase in which inflation remains high while unemployment increases. 3) The recovery phase is a phase in which inflation and unemployment both decline. 4) The pattern of a sequence from Phillips phase, to stagflation phase, to recovery phase is termed the inflation-unemployment cycle.

7. II Explaining the Inflation-Unemployment Cycle A) The Phillips Phase: Increasing Aggregate Demand. The Phillips phase occurs as increases in aggregate demand (I.e. a shift in the aggregate demand curve) move the short run equilibrium along the short run aggregate supply curve.

9. B) Changes in expectations and the Stagflation Phase. This phase occurs because workers and thus firms begin to expect inflation and thus build it into labor contracts and other prices. This results in a shift of the short run aggregate supply curve to the left, thus generating price increases along with a drop in the short run level of output and employment.

11. C) The Recovery Phase. This phase occurs because of the response of policy makers to the fall in equilibrium output which occurred in the stagflation phase. In particular, during the stagflation phase, we saw that short run output fell below potential. We would expect policy makers to stimulate the economy thus shifting the aggregate demand curve outward. The net result is lower inflation and higher output and employment in the short run.

13. III Inflation and Unemployment in the Long Run. • The Inflation Rate in the Long Run 1) If the velocity of money is constant, (i.e. % AV = 0) then the equation of exchange implies, % AP = % AM - % AYp. 2) Since potential output historically has grown at 2.5%, we see that long run prices are really determined by long run monetary growth rates.

14. B) Unemployment in the Long Run 1) Recall there are three types of unemployment: frictional, structural, and cyclical. 2) In the long run only frictional and structural are at issue since cyclical is by definition a short run phenomena. 3) Basics behind frictional unemployment a) The lowest wage that an unemployed worker will accept is called the reservation wage.

15. b) A simple search model. i) An individual starts with a reservation wage of W0 and reduces it as time passes during their job search. ii) The best offer received by an individual gets better as the agent receives more offers. iii) Equilibrium duration offers at the intersection of the reservation wage curve and the best offer curve.

17. c) Things that can influence the equilibrium duration of time. i) Job market information is easier to obtain. This shifts the best offer curve left, thus lowering the job search duration and frictional unemployment. ii) Unemployment insurance increases the reservation wage. This shifts the reservation wage curve right, thus raising the job search duration and frictional unemployment.

18. 4) Structural unemployment occurs because some workers who were trained for occupations no longer in demand thus do not posses the skills for jobs currently in demand. a) Structural unemployment can be reduced by job training programs or b) job announcements for regions of the country that may still demand those skills.

19. 5) Cyclical Unemployment and Efficiency Wages. a) Some economists argue that there are different reasons that explain the long run level of unemployment. They argue that wages are not determined as a results of some market equilibrium and that the market wage may stay above the market equilibrium wage. b) An efficiency wage is a wage greater than the equilibrium wage.

20. c) The most common reasons for efficiency wages is that it increases worker loyalty and productivity. d) If these exist then the ordinary process of self correction will not eliminate a recessionary gap.