Economics Micro & Macro (CliffsAP)

Figure 6-5

You will need to understand the Philips Curve model for the AP exam. Usually, the exam includes several questions
related to the Phillips Curve, with some graphical analysis in the multiple-choice section.

Expected and Unexpected Inflation

Unexpected inflation affects the unemployment rate through three factors: wage expectations, inventory changes, and
wage contracts.

Wage Expectations

Unemployed workers who are looking for a job specify a wage that they will be comfortable accepting as monetary
compensation. Workers continue to search for work until they meet or exceed this particular wage.

The correlation between unexpected inflation and the unemployment rate stems from the fact that wage offers are unex-
pectedly high when inflation is unexpectedly high. A surprising increase in inflation means that prices are higher than
anticipated, as are nominal income and wages. If aggregate demand increases unexpectedly, it has a positive influence
on prices, output, employment, and wages. If a worker has a set wage in his mind that he is willing to work for, then
any unexpected rise in wages will employ the worker. In essence, more unemployed workers find jobs, and they find
those jobs quicker than they do in a period where inflation is expected. The unemployment rate falls during a period of
unexpected inflation.

Suppose a teacher named Michelle decides that she must find a job that pays at least $100 a day. Michelle’s minimum
wage expectation is $100, and she expects prices and wages to be pretty stable while she is looking for a job (she ex-
pects no inflation). As Michelle is looking for a job, she finds that the ones she qualifies for are only offering her $90 a
day. Because her offers are all paying less than her minimum wage, Michelle keeps looking for a job. Now let’s say that
aggregate demand increases unexpectedly. This translates into firms increasing production and raising prices. Firms
now need to hire more workers to meet the demands of their customers. Now that firms need more workers, they must
create incentives for workers to come work for them, so they raise wages. If wages increase 5 percent, now the jobs
Michelle qualifies for are paying 5 percent more than they were. These wages now meet Michelle’s minimum wage,
and Michelle is no longer unemployed.

Price Level

Unemployment Rate

Phillips Curve

(Long Run)

5

8

2

10

0% 5% 10 %

Part II: Macroeconomics