In this chapter we examine this tradeoff more closely. The relationship between inflation and unemployment is a topic that has attracted the attention of some of the most important economists of the last half century. The best way to understand this relationship is to see how thinking about it has evolved over time. | 35 The Short-Run Tradeoff between Inflation and Unemployment Unemployment and Inflation The natural rate of unemployment depends on various features of the labor market. Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed. Unemployment and Inflation Society faces a short-run tradeoff between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. THE PHILLIPS CURVE The Phillips curve illustrates the short-run relationship between inflation and unemployment. Figure 1 The Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B 6 7 A 2 Copyright © 2004 South-Western Aggregate . | 35 The Short-Run Tradeoff between Inflation and Unemployment Unemployment and Inflation The natural rate of unemployment depends on various features of the labor market. Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed. Unemployment and Inflation Society faces a short-run tradeoff between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. THE PHILLIPS CURVE The Phillips curve illustrates the short-run relationship between inflation and unemployment. Figure 1 The Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B 6 7 A 2 Copyright © 2004 South-Western Aggregate Demand, Aggregate Supply, and the Phillips Curve The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. Aggregate Demand, Aggregate Supply, and the Phillips Curve The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. A higher level of output results in a lower level of unemployment. Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output 0 Short-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level (b) The Phillips Curve Phillips curve Low aggregate demand High aggregate demand (output is 8,000) B 4 6 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7,500 102 A Copyright © 2004 South-Western SHIFTS IN .
