INFLATION AND UNEMPLOYMENT : PART ONE

RELATED CONCEPTS:|ACCELERATIONIST THEORY | COLD TURKEY AND GRADUALISM |DEMAND-PULL AND COST-PUSH INFLATION |EXPECTED RATE OF INFLATION | LONG-RUN PHILLIPS CURVE | NATURAL RATE OF UNEMPLOYMENT |PHILLIPS CURVE | TAX-BASED INCOME POLICY (TIP) |

How can you tell what the expected price level is by looking at the AD/AS diagram?

• The expected price level is where the AS curve intersects the long-run aggregate supply curve (i.e., at full employment).

How can you tell what the expected rate of inflation is by looking at the Phillips Curve?

• The expected inflation rate is where the Phillips Curve intersects the long-run Phillips Curve (at the natural rate of unemployment).

Along a Phillips Curve, how are inflation, unemployment, and output related? What is being held constant?

• More inflation means less unemployment and so more output. The AS curve and the expected rate of inflation are held constant along the Phillips Curve.

In what sense are workers “fooled” by inflation?

• Workers set their wages based upon what they think the price level will be. But if inflation is greater than they expected, they will have been “fooled” into accepting a lower real wage than they wanted.

How will the economy eventually get to the price level where the AD curve intersects the long-run aggregate supply curve?

• If output differs from the full-employment level of output, workers will adjust their expectations and wages so the AS curve shifts the economy along the AD curve towards full employment.

Will a higher rate of inflation always reduce unemployment?

• No. Inflation reduces unemployment only if inflation is higher than expected. If it’s lower than expected, unemployment will go up.

What happens to the Phillips Curve when people expect higher rates of inflation?

• If people expect higher rates of inflation, they will demand higher wages and raise other factor costs. The Phillips Curve and the AS curve will shift up.

Why must inflation accelerate in order to reduce unemployment below its natural rate?

• Because if inflation doesn’t accelerate, the expected rate of inflation will catch up with the actual rate, returning unemployment to its natural level.

What rate of unemployment and what output level can be sustained in the long run?

• Only the natural rate of unemployment and the full-employment level of output can be sustained in the long run.

If wage and price controls worked, how could they help speed the recovery of an economy?

• Wage and price controls could speed the recovery of an economy if they corrected the mistaken judgment of people as to how high prices and inflation will be. This would cause the AS curve to shift more quickly towards full employment.

Copyright 2008 by Sujanto Rusli
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