The Phillips Curve - Inflation vs Unemployment

Summary

This video explains the trade-off between inflation and unemployment using the short-run and long-run Phillips curves. It demonstrates how increasing aggregate demand can reduce unemployment but raise inflation, while decreasing demand has the opposite effect. The video also introduces Milton Friedman’s view of the long-run Phillips curve, which suggests a natural rate of unemployment. The impact of supply shocks, such as a rise in oil prices, leading to stagflation is covered. Through visual aids and models, the video illustrates these economic relationships, helping viewers understand the dynamic between inflation, unemployment, and economic shifts.

Takeaways

• 😀 The trade-off between inflation and unemployment arises because measures to boost aggregate demand can increase both output and employment, placing upward pressure on wages and leading to demand-pull inflation.
• 😀 When aggregate demand increases, unemployment tends to fall, but inflation may rise due to higher wages and costs.
• 😀 In times of recession, unemployment typically spikes, and inflation often falls, as seen in historical data from the Federal Reserve Bank.
• 😀 Measures to decrease aggregate demand can cause both output and employment to decrease, as well as put downward pressure on wages, resulting in lower inflation and higher unemployment.
• 😀 A negative supply shock, like a rise in oil prices, can lead to stagflation, where both unemployment and inflation rise simultaneously.
• 😀 The Phillips curve shows an inverse relationship between unemployment and inflation in the short run, meaning as unemployment increases, inflation tends to fall.
• 😀 Milton Friedman and Edmund Phelps challenged the short-run Phillips curve by arguing that the government can't permanently lower unemployment at high inflation, as inflationary expectations adjust over time.
• 😀 The long-run Phillips curve, according to Friedman, is vertical at the natural rate of unemployment, indicating that inflation does not affect the long-term unemployment rate.
• 😀 The classical aggregate demand and aggregate supply model shows that a shift in aggregate demand can temporarily raise output and decrease unemployment, but inflationary expectations lead to a leftward shift in the short-run aggregate supply curve, returning the economy to the natural rate of unemployment at a higher price level.
• 😀 Stagflation can be explained through shifts in both aggregate supply and the Phillips curve, where both inflation and unemployment rise due to a leftward shift in the short-run aggregate supply curve.

Q & A

What is the main trade-off discussed in the video?

The video explores the trade-off between inflation and unemployment, emphasizing that measures to boost aggregate demand can lower unemployment but may increase inflation.

How does an increase in aggregate demand affect inflation and unemployment?

An increase in aggregate demand leads to higher output and employment, which can cause upward pressure on wages and resources, resulting in demand-pull inflation. This lowers unemployment but may increase inflation.

What does the data from the Federal Reserve Bank demonstrate?

The data shows that unemployment often spikes during recessions, and as unemployment rises, inflation typically falls. It provides a historical view from just before 1950 to the present.

What happens when aggregate demand decreases?

When aggregate demand decreases, output and employment may fall, leading to downward pressure on wages and a decrease in the price level. This results in higher unemployment and lower inflation.

What is stagflation, and how does it occur?

Stagflation is a situation where the economy experiences both high inflation and high unemployment. It typically occurs after a negative supply shock, such as a sudden rise in oil prices, which increases costs and reduces output.

What is the short-run Phillips curve, and what does it illustrate?

The short-run Phillips curve (SRPC) illustrates an inverse relationship between inflation and unemployment, showing that as unemployment decreases, inflation tends to increase.

How did Milton Friedman and Edmund Phelps challenge the Phillips curve?

Friedman and Phelps argued that the government could not permanently lower unemployment at high inflation rates. They believed inflationary expectations would push wages up, and in the long run, the economy would return to the natural rate of unemployment (NRU).

What does the long-run Phillips curve represent?

The long-run Phillips curve, as proposed by Friedman, is a vertical line at the natural rate of unemployment (NRU), suggesting that no permanent trade-off exists between inflation and unemployment in the long run.

How does the classical aggregate demand and aggregate supply model relate to the Phillips curve?

In the classical model, the long-run aggregate supply curve is vertical at the natural rate of unemployment. An increase in aggregate demand shifts the AD curve rightward, leading to higher output and inflation. As inflation expectations rise, the short-run aggregate supply curve shifts left, returning the economy to the natural rate of unemployment.

What happens when the short-run aggregate supply curve shifts leftward?

When the short-run aggregate supply curve shifts leftward, it results in higher prices and lower output, which mirrors a rightward shift of the short-run Phillips curve, leading to higher inflation and higher unemployment.