Inventory Fluctuations and Unemployment
Businesses hold inventories based on what they expect their sales to be. When aggregate demand becomes greater than
what was expected, shortages are created and inventories fall below targeted levels. To compensate for this sudden increase
in aggregate demand, firms increase production to restore inventory levels to optimum numbers. This increase in produc-
tion leads to an increase in employment. The opposite can happen when inventories are higher than expected; firms lay
off workers (thus reducing their labor force) or cut back on employment (hire fewer new workers) when inventories are
too high.
Inventory, production, and employment are all key parts of the Phillips Curve. When firms form expectations on sales
and inventory, they look at expected levels of aggregate demand. If aggregate demand is greater than expected, invento-
ries fall, prices increase, and employment rises. If aggregate demand is less than expected, inventories rise, and prices
and employment fall. With an unexpected rise in inflation, the unemployment rate falls as businesses hire more workers
to increase output to offset falling inventories.
Mini-Review
- Which one of the following is true regarding the Phillips Curve?
A. It measures profits and revenue.
B. It can only be used with nominal GDP.
C. The relationship between taxes and inflation is measured by this curve.
D. It measures the relationship between price level and unemployment.
E. Economists really have no use for it. - Which statement best describes the short-run relationship between unemployment and the price level?
A. Unemployment and the price level are positively related.
B. Unemployment and the price level are inversely related.
C. There is no relationship.
D. The relationship depends on the level of GDP.
E. None of the above. - What is the main difference between the long-run Phillips Curve and the short-run Phillips Curve?
A. In the long run, everything relates to inflation; in the short run, everything relates to unemployment.
B. The short-run unemployment is influenced by inflation; in the long run, inflation does not affect
unemployment.
C. The short run and the long run are the same.
D. There is no short-run Phillips Curve.
E. In the short run, both curves affect inflation, and in the long run, both curves affect unemployment.
Mini-Review Answers
- D. The Phillips Curve measures the relationship between unemployment and the price level.
- B.Unemployment and inflation are inversely related in the short run.
- B.In the short run, unemployment is affected by inflation; in the long run, inflation does not affect
unemployment.
Monetary Policy