Chapter 35: The Short-Run Tradeoff between Inflation and Unemployment

A short-run tradeoff exists between unemployment and inflation. This means if policymakers expand aggregate demand, they can lower unemployment at the expense of higher inflation as graphically represented by the Phillips curve. A greater aggregate demand means greater economic output and higher price level, which in turn means a lower level of unemployment. The long-run Phillips curve is vertical at the natural rate of unemployment. Monetary policy can be effective in the short run but not in the long run. In the long run, expected inflation adjusts to changes in actual inflation. Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. In the long run, the Phillips curve is vertical because short run fluctuations always lead back to the naturate rate of unemployment, and the increases/decreases in inflation year to year. In addition, changes in nominal values (inflation/deflation) have no effects on real values, and thus, change in supply of money (inflation/deflation) cannot change unemployment in the long run. An increase in the supply of money increases aggregate demand, which raises price level, increasing inflation rate on the LR Phillips curve, but keeping quantity of output constant. in the long run.