Economics Micro & Macro (CliffsAP)

A Closer Look at Unemployment and Inflation

Low unemployment and low inflation are both goals of economic policymakers. Both monetary and fiscal policy offi-
cials seek these goals with the intention of stabilizing the economy. In the short run, there is a trade-off between the rate
of inflation and unemployment. The Phillips Curveillustrates the relationship between unemployment and inflation.
As fiscal policies are designed to eliminate unemployment, there comes a point where a decrease in unemployment will
cause an increase in inflation.

A Short-Run Phillips Curve

In the short run, there is a trade-off between unemployment and inflation because an increase in spending increases out-
put and stimulates employment. As the unemployment rate falls due to higher spending, the inflation rate rises. This
trade-off between unemployment and inflation is temporary.

Figure 6-4 below is an example of a Phillips Curve in the short run.

Figure 6-4

In the graph in Figure 6-4, we can move from an unemployment rate of 10 percent to 5 percent with little or no impact
on the price level. However, when we move past 5 percent unemployment, you can see that the price level begins to rise
significantly. In the short run, a trade-off exists between unemployment and inflation. In the long run, there is no trade-
off because the economy is at full employment.

A Long-Run Phillips Curve

The long run produces no trade-off between unemployment and inflation because aggregate supply shifts to stabilize
the price level. The shift in aggregate supply lowers real GDP. As income falls, the unemployment rate goes up. In the
long run, as the economy adjusts to an increase in aggregate demand and expectations adjust to the new inflation rate,
there is a period in which real GDP falls and the price level rises.

Over time, there is no relationship between the price level and the level of real GDP. The long-run Phillips Curve in
Figure 6-5 shows that there is no relationship between real GDP and the price level.

Price Level

Unemployment Rate

Phillips Curve

(Short Run)

5

8

2

10

0% 5% 10 %

Monetary Policy