THESHORT-RUN21TRADEOFFBETWEENINFLATIONANDUNEMPLOYMENT.pdfVIP

THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND 21 UNEMPLOYMENT LEARNING OBJECTIVES: By the end of this chapter, students should understand: ? why policymakers face a short-run tradeoff between inflation and unemployment. ? why the inflation-unemployment tradeoff disappears in the long run. ? how supply shocks can shift the inflation-unemployment tradeoff. ? the short-run cost of reducing inflation. ? how policymakers’ credibility might affect the cost of reducing inflation. KEY POINTS: 1. The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment. 2. The tradeoff between inflation and unemployment described by the Phillips curve holds only in the short run. In the long run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips curve shifts. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. 3. The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as the increase in world oil prices during the 1970s, gives policymakers a less favorable tradeoff between inflation and unemployment. That is, after an adverse supply shock, policymakers have to accept a higher rate of inflation for any given rate of unemployment, or a higher rate of unemployment for any given rate of inflation. 4. When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve, which results in temporarily