7/31/2019 Economics For Managers GTU MBA Sem 1 Chapter 33

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By:

Prof. Sharif Memon

7/31/2019 Economics For Managers GTU MBA Sem 1 Chapter 33

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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 effectivenessof job search.

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Society faces a short-run tradeoff between

unemployment and inflation.

If policymakers expand aggregatedemand, they can lower unemployment,

but only at the cost of higher inflation.

If they contract aggregate demand, theycan lower inflation, but at the cost of

temporarily higher unemployment.

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The Phillips curve illustrates the

short-run relationship between

inflation and unemployment.

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UnemploymentRate (percent)0

InflationRate

(percentper year)

4

B6

A

7

2

Phillips curve

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The greater the aggregate demand for

goods and services, the greater is the

economys output, and the higher is theoverall price level.

A higher level of output results in a lower

level of unemployment.

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Phillips curve

0

(b) The Phillips Curve

Inflation Rate(percent per

year)

UnemploymentRate (percent)

0

(a) The Model of AD and AS

Price Level

Low AD

High AD

B

4

6

(output is8,000)

A

7

2

(output is7,500)

A

7,500

102

(unemploymentis 7%)

B

8,000

106

(unemploymentis 7%)

Short-runAS

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In the 1960s, Friedman and Phelps

concluded that inflation and

unemployment are unrelated in the longrun.

As a result, the long-run Phillips curve is

vertical at the natural rate ofunemployment.

Monetary policy could be effective in the

short run but not in the long run.

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UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

B

High

inflation1. When theRBI increasesthe growthrate of themoneysupply, the

rate ofinflationincreases

2. but

unemploymentremains at itsnatural ratein the long run.

ALowinflation

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Expected inflation measures

how much people expect the

overall price level to change.

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In the long run,expected inflation adjuststo changes in actual inflation.

The RBIs ability to create unexpected

inflation exists only in the short run.

Once people anticipate inflation, the only

way to get unemployment below the naturalrate is for actual inflation to be above the

anticipated rate.

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UnemploymentRate =

Natural rate ofunemployment

Actual Expected

inflation inflation-

( )a-

This equation relates the unemployment rateto the natural rate of unemployment, actual

inflation, and expected inflation.

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The view that unemployment

eventually returns to its natural rate,

regardless of the rate of inflation, iscalled the natural-rate hypothesis.

Historical observations support the

natural-rate hypothesis.

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In the 1970s, policymakers faced two

choices when OPEC cut output and

raised worldwide prices of petroleum.

Fight the unemployment battle by expanding

aggregate demand and accelerate inflation.

Fight inflation by contracting aggregatedemand and endure even higher

unemployment.

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The theory of rational expectations

suggests that people optimally use allthe information they have, including

information about government policies,

when forecasting the future.