Inflation and Unemployment

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• 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 1960s, but has been
  less stable during more recent years.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.