Chapter 35. The Short-Run Trade-off between Inflation and Unemployment.

Summary

This video explores the short-term trade-off between inflation and unemployment, drawing from Gregory Mankiw's 'Principles of Economics'. It discusses the Phillips Curve, illustrating the negative correlation between unemployment and inflation rates in the short run. The video explains that while policy interventions can influence these variables temporarily, in the long run, factors like market power and efficiency wages determine unemployment, and monetary policy cannot alter the natural rate of unemployment. It also covers the impact of supply shocks, like the OPEC oil crisis, and the importance of expectations in shaping the Phillips Curve.

Takeaways

• 📚 The video discusses the short-run trade-off between inflation and unemployment based on 'Principles of Economics' by Gregory Mankiw.
• 🔍 Unemployment is influenced by the labor market, minimum wage laws, and job search effectiveness, while inflation is affected by money supply growth.
• 🔄 In the long run, unemployment and inflation rates are not related, according to experiments based on U.S. data.
• 🛠 Policymakers, such as the government and central banks, can use fiscal or monetary policy to influence unemployment and price levels in the short run.
• 🔑 The short-run correlation between unemployment and inflation is negative, implying that reducing unemployment can lead to higher inflation.
• 🎯 Central banks aim to stabilize the purchasing power of money, which may result in higher unemployment as a trade-off for lower inflation.
• 📈 The Phillips Curve illustrates the relationship between the rate of unemployment and the rate of change of money wages, with an inverse relationship observed historically.
• 📊 Aggregate supply and demand analysis shows that an increase in demand can lead to higher prices and output, affecting the Phillips Curve.
• 🌐 Shifts in the Phillips Curve are influenced by expectations, with changes in the slope over time reflecting variability in these expectations.
• 🔮 Milton Friedman's work suggests that in the long run, there is no relationship between inflation and unemployment, leading to a vertical long-run Phillips Curve.
• 🌟 The natural rate of unemployment is the rate towards which the economy gravitates in the long run and is influenced by factors such as market power of unions and efficiency wages.
• 🛑 Supply shocks, such as those caused by OPEC restricting oil supply, can shift the Phillips Curve, leading to higher unemployment and inflation rates in the short run.

Q & A

What is the main topic of the video?

The main topic of the video is the short-run trade-off between inflation and unemployment, as discussed in Gregory Mankiw's 'Principles of Economics'.

What is the relationship between unemployment and labor market factors?

Unemployment is influenced by factors in the labor market, including minimum wage laws and the effectiveness of job search.

How does the inflation rate depend on money supply?

The inflation rate is dependent on the growth in money supply, as demonstrated by experiments based on real data from the United States.

What is the conclusion about the long-term relationship between unemployment and inflation?

In the long run, unemployment and inflation are not related, according to the experiments and data analysis.

Who are the policy makers referred to in the script?

The policy makers referred to are the government, which can implement fiscal policy, and the central bank, which can implement monetary policy.

What is the short-term correlation between unemployment and inflation according to the video?

In the short run, there is a negative correlation between unemployment and inflation, meaning that when one decreases, the other tends to increase.

What did A.W. Phillips discover in his paper about the UK economy?

A.W. Phillips discovered an inverse relationship between employment and the rate of change of money wages in the UK economy from 1861 to 1957.

What is the basic idea behind the Phillips curve representation in the video?

The basic idea is that higher output leads to greater employment and a lower unemployment rate, but this can result in a higher price level due to increased consumption.

What is the role of expectations in the Phillips curve?

Expectations play a crucial role as they can cause variability in the slope of the Phillips curve over time, reflecting how quickly people adjust their expectations of inflation.

What is the natural rate of unemployment and why is it important?

The natural rate of unemployment is the rate toward which the economy gravitates in the long run. It is important because it represents the basic or natural value of unemployment that will be maintained in the long run, and it cannot be influenced by monetary policy.

How can supply shocks affect the Phillips curve?

Supply shocks, such as the OPEC oil crisis, can shift the Phillips curve to the right, indicating that for the same level of inflation, there will be a higher level of unemployment.

What is the conclusion about the trade-off between inflation and unemployment in the long run?

In the long run, the trade-off suggests that there is a cost of higher unemployment for lower inflation, but ultimately, the unemployment rate will return to its natural rate regardless of the inflation rate.

How do rational expectations affect the Phillips curve?

Rational expectations affect the Phillips curve by adjusting how quickly people update their expectations of inflation, which can either shift the curve or leave it unchanged depending on whether they believe a change in inflation is temporary or permanent.

Outlines

00:00

📚 Introduction to the Short-Run Trade-Off between Inflation and Unemployment

This paragraph introduces the concept of the short-run trade-off between inflation and unemployment, drawing from Gregory Mankiw's 'Principles of Economics'. It explains how unemployment is influenced by labor market conditions, minimum wage laws, and job search effectiveness, while inflation is tied to money supply growth. The script notes that in the long run, these variables are not related, but in the short run, they exhibit a negative correlation. The role of policy makers, either through fiscal or monetary policy, is highlighted in influencing these variables. The paragraph also references the Phillips curve, which historically showed an inverse relationship between employment and the rate of change of money wages, and discusses the impact of aggregate demand on prices and output.

05:01

🔍 The Long-Run Phillips Curve and the Concept of Natural Unemployment

The second paragraph delves into the long-run implications of the Phillips curve and introduces the concept of the natural rate of unemployment. It discusses how in the long run, monetary policy cannot influence this natural rate, and that real changes are necessary to affect it. The paragraph also touches on the dichotomy of classical economics, which posits that money growth does not affect real variables in the long run. The role of expectations in the Phillips curve is explored, emphasizing how changes in expected inflation can shift the curve and affect the trade-off between inflation and unemployment. The impact of supply shocks, such as those caused by OPEC's oil restrictions, is also examined, showing how they can shift the aggregate supply and Phillips curve, leading to higher unemployment and inflation.

10:03

🛠 The Role of Expectations and Supply Shocks in Inflation Dynamics

The final paragraph focuses on the role of expectations and supply shocks in the dynamics of inflation. It explains how people's beliefs about the permanence of inflation can affect the Phillips curve, with temporary inflation not altering the curve, but a new area of inflation leading to a shift. The paragraph discusses the impact of the Organization of the Petroleum Exporting Countries (OPEC) as a significant example of a supply shock that can shift the Phillips curve to the right, resulting in higher unemployment at the same level of inflation. The concept of rational expectations is introduced, suggesting that the speed at which people adjust their inflation expectations can influence economic outcomes. The paragraph concludes by emphasizing the trade-off between inflation and unemployment in the short run and the inevitability of returning to the natural rate of unemployment in the long run.

Keywords

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. In the video, it is discussed as a variable that is dependent on money supply growth and is a key aspect of the short-run trade-off with unemployment. The script mentions that in the long run, inflation and unemployment are not related, which is a significant point in understanding economic policies and their effects.

💡Unemployment

Unemployment is the state of the labor force where individuals are without jobs and actively seeking work. The video script explains that unemployment is influenced by the labor market conditions, minimum wage laws, and the effectiveness of job search. It is also highlighted as one end of the trade-off spectrum with inflation in the short run, but not related to inflation in the long run.

💡Phillips Curve

The Phillips Curve is an economic concept that illustrates an inverse relationship between unemployment and inflation rates. The video script describes how this curve represents the short-run trade-off between these two variables, showing that lower unemployment rates are associated with higher inflation, and vice versa. The curve is central to the discussion of the dynamic relationship between inflation and unemployment.

💡Aggregate Supply and Demand

Aggregate Supply and Demand are macroeconomic measures of the total quantity of goods and services available in an economy (supply) and the total quantity that the economy is willing to purchase (demand). The video script uses these concepts to explain how changes in aggregate demand can lead to changes in price levels and output, which in turn affect inflation and unemployment rates.

💡Policy Makers

Policy Makers in the context of the video refer to government officials or central bank authorities who have the power to influence economic policy. The script discusses how policy makers can use fiscal or monetary policy to impact unemployment and inflation rates in the short run, but not the natural rate of unemployment in the long run.

💡Money Supply

Money Supply is the total amount of money available in an economy at a point in time. The video script indicates that the growth in money supply is a determinant of the inflation rate. It is a key factor in the central bank's efforts to control inflation through monetary policy.

💡Natural Rate of Unemployment

The Natural Rate of Unemployment is the unemployment rate that exists in the economy when it is at its natural level of output, with all prices and wages being flexible. The video script explains that this rate is not influenced by monetary policy in the long run and is determined by factors such as market power of unions and efficiency wages.

💡Expected Inflation

Expected Inflation is the anticipated rate of increase in the general level of prices in the future. The video script discusses how expected inflation can shift the Phillips Curve and affect the trade-off between unemployment and inflation. It is a crucial concept in understanding how changes in expectations can influence economic outcomes.

💡Supply Shocks

Supply Shocks refer to sudden, unexpected events that disrupt the supply side of the economy, leading to changes in production costs and availability of goods and services. The video script uses the example of the Organization of Petroleum Exporting Countries (OPEC) restricting oil supply, which led to increased price levels and a shift in the Phillips Curve, illustrating the impact of supply shocks on the economy.

💡Rational Expectations

Rational Expectations is a theory in economics that assumes individuals and businesses form their expectations about the future in a manner that is consistent with available information and the true economic model. The video script mentions that the speed at which people adjust their expectations of inflation can influence the effectiveness of economic policies and the position of the Phillips Curve.

Highlights

The video discusses the short-run trade-off between inflation and unemployment based on Gregory Mankiw's 'Principles of Economics'.

Unemployment is influenced by the labor market, minimum wage laws, and job search effectiveness.

Inflation rate is determined by growth in money supply and is not related to unemployment in the long run.

Policy makers can use fiscal or monetary policy to influence unemployment and price levels in the short run.

Central banks aim to stabilize the purchasing power of money, which may lead to higher unemployment.

Phillips curve demonstrates an inverse relationship between employment and the rate of change of money wages.

Samuelson and Solow's analysis of the USA supports the Phillips curve concept.

Larger output leads to greater employment and potentially a higher price level due to increased consumption.

Aggregate supply and demand representation shows the impact of demand increase on price levels and output.

The Phillips curve shifts due to changes in expectations about inflation.

Classical economics suggests that money growth does not affect real variables in the long run.

Friedman's data analysis found no long-run relationship between unemployment and inflation.

The natural rate of unemployment is related to long-run factors such as market power and efficiency wages.

Monetary policy cannot influence the natural rate of unemployment in the long run.

Supply shocks, like those from OPEC, can shift the Phillips curve to the right, increasing unemployment at the same inflation rate.

Expected inflation affects the sensitivity of the unemployment rate based on the gap between actual and expected inflation.

In the long run, the actual inflation equals expected inflation, leading to unemployment returning to its natural rate.

Rational expectations theory suggests that how quickly people adjust their inflation expectations affects economic outcomes.

The video concludes that reducing inflation may come at the cost of higher unemployment.

Transcripts

hi welcome on to this video we're going

to develop now charter 35 the short run

trade-off between inflation and

unemployment

this is a book of gregory monkey

principles of economics

so we we already know that unemployment

definitely depends on labor market

on all the minimum wage laws and even

the effectiveness of

job search from the other side we know

that the inflation rate depends on

growth

in money supply and actually

after several experiments

and those experiments based on real data

basically from united states

the the conclusion is that in the long

run these two variables

unemployment and inflation rate they are

not

related so we know that the policy

makers they can

expand engagement who are the policy

makers we are talking about the

government

it means fiscal fiscal policy or we are

talking about

the central bank then monetary policy

then uh at this point we can um

the unemployment will decrease and then

the price level will increase

so what we are going to have a look here

it's like in the la in the

in the short run unemployment and

inflation they are correlated

negatively okay so then

from one side we know that the central

bank the objective for

most of the central bank to keep the

powerful acquisition of all people

stable then they the

aim is to reduce inflation or to keep at

least stable

but then the cost could be

higher unemployment then

after after a paper

written by phillips an economist

the relationship between employment and

rate of

change of money wages in the united

kingdom

during 1861 1957

uh they discovered or he discovered that

there is a relationship

inverse between these two variables then

other prominent economists sam also and

solo

made these analysis for usa and then

the idea is basic is simple yet we have

larger

output means that greater employment

and then naturally lower rate of

unemployment

and due to the success of consumption

the concept for

the consequence could be higher price

level

then we have this uh this representation

of the aggregate supply

and aggregate demand and then

in this one we have an increase for

example for this data we have an

increase in the aggregate

demand so we have the now the

equilibrium is the price that is 106.

this 106 is the index of the cpi the

consumer

consumer price index we know that over

100

is an increase compared with the word

base year

basically we made a comparison year by

year

and then we have here higher level

prices by higher level of

output then if we want to represent that

in the philips curve

it relates inflation in the y-axis and

unemployment rate in the x-axis

we have here when the inflation is

equivalent to two percent

we have higher level of unemployment and

for an output of

5 or 15 000 then we can achieve

higher output but the cost should be

uh definitely higher inflation

shifts in the philips curve then

it started to have the idea of the role

of expectation

why because well basically first

something to we need to have clear is

that

if there is actually a variability

in the slope over time in this phillips

curve

well it appears in these uh in these

expectations

so actually what we learned

from classical economies is the demonic

growth

it doesn't have a it doesn't it doesn't

have any change in variables

uh in real variables it has more

more uh more

effect actually in uh in the nominal

ones

this is the basic idea so for this

reason this phillips curve

it it has a relevance in the short

run then uh we know that the

unemployment rate at least in the long

run

in the long run actually is changed by

market power of unions or even the role

of efficiency wages

then uh actually for this reason

friedman

said and actually after several data

discover no relationship the long run

between these two variables

then we have the core phillips is

vertical

and then it's a valid situation or is a

confirmation for the dichotomic of a

classical

that money growth doesn't change

anything in viable

and real variables at least in the long

run so here we have inflation and the

unemployment rate

and then we are going to be talking

about the natural rate of unemployment

which is definitely related with the

with the future with the long run and

the aggregate supply

with the natural level of output

then uh then here

basically what we have here when we have

uh the situation

of the in the long run we have an

increase

in the aggregate demand um

in this situation well the only

situation that we are going to generate

is an increase in the price level

not any change in other in other

variables at least in the long run

then here when we talk about natural

well

this is unemployment rate toward which

the economy gravitates in the long run

it's like the basic

or the or the natural value

the the unemployment will be kept

uh in the in the long run and it is

really important to

uh take into consideration that monetary

policy

cannot influence natural rate of

unemployment

just like real changes really could

change this variable

and then when we make a comparison

between theory and evidence

well actually we we have a look that

uh that basically the the facts

are really related what we have in the

theory

uh at the end this logic of the

aggregate supply it applies to the long

run

remember that when we talk about

aggregate supply in the long run it's

vertical

because the prices can adjust uh

in the long run the basic for example

the theory of the sticky wages

maybe the loan in the short run you

cannot just wages but in the long run

they are easily uh adjusted and then

those variables are more affected by

expected inflation

here is the the question that we're

going to face with the unemployment rate

we have a natural rate of employment

unemployment and then minus a this

should go

this a factor is going to be the

sensitivity

of of the unemployment rate

based on the gap between actual

inflation

and inspected inflation the expected

inflation is given

is higher than uh actual inflation so we

have a

naturally lower um lower unemployment

in the long run the actual inflation is

equal to

expected inflation because um everybody

knows we should be

effectively like value so unemployment

rate equal to the natural rate of

unemployment

so then when there is an expected

inflation that changes

it shifts the curve it depends to the

right

or to the to the to the left

but in the short run which is really

important and the most relevant during

20th

century is the trade-off between these

two variables

then for example here when we have the

representation of the long run

phillips curve and then we have here the

short run

basically when we face a change from

this

curve the the the one down to this one

we can express in the short run a change

from a to b

so higher inflation lower level

of unemployment but if anything changes

at the end of the day we're going to

have dana c

point then we're going just to have the

same level

of of of inflation

but higher level of unemployment

so then basically um the situation here

is just like the

unemployment will return to natural rate

regardless

the rate of inflation so just in the in

the short run policy makers

can take or use this tool to change

but in the long run more real variables

should be necessary

so then uh in this situation the the

supply shocks

can definitely make some changes into

the philips curve can

shift this curve to the right actually

the

one of the most important the one the

one of the

most important um example is

organization of petroleum

of exporting countries the opec

well actually they restricted the amount

of crude oil they pump it

and actually it increased the price

level

it shifts aggregate supply and philips

curve

so here we have an example we have here

an expanding inflation rate

in the y-axis unemployment rate in the

x-axis

and then we have the level of the

aggregate demand in the the right side

and here we have the in the in the left

side is not the monetary

and supply is more the aggregate and on

on demand and okay supply and here we

have this shock of supply which was a

decrease

in the supply of oil so it generates

naturally a decrease

in the total output and an increase in

the price level

and as a consequence we have here a

shift to the right

for the phillips curve it means the same

level

of the same level of inflation

higher level of unemployment associated

with this situation disregard is why

that i didn't cancel them out so

actually this is the two important facts

that we need to take into account

if people believe that it is temporary

expected inflation will not change the

philips curve however

if people believe that this is a new

area of inflation philips curve

will change so what is the cause of

reduction inflation

basically the answer more unemployment

is just like the basic conclusion of

this chapter

so then here we have the situation and

when we have

uh these naturally we have from

a uh in the short run we are going to

move to b

so then show our inflation by higher

level of unemployment

but in the long run we're going to face

then

lower uh lower limit employment but the

same level of

inflation so this is the cost more

unemployment that you need to you need

to face

so then uh this rational expectation

explained uh depends on how quickly

people adjust their expectation of

inflation if they change from the things

uh

that federal reserve says on the economy

says about the

cannot economy in general then is going

to be

any effort or is going to be any change

into the real economy

okay so that's basic is like more about

it's not

not a lot of questions not a a lot of

maths

just like have an idea that the core

philips where it comes from

and some some interesting idea

about what happening between the

trade-off

inflation and employment thank you so

much

see you next video bye-bye