Phillips Curve

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Phillips curve is an inverse relationship between the rate of unemployment and the rate of inflation in an economy. The original curve stated a negative relationship between money wage changes and unemployment. Later on, it was shown that there was a permanent stable relationship between inflation (price level) and unemployment. It means that the government could control unemployment and inflation through monetary policy. For example, fiscal policy could be used to stimulate the economy, raising GDP and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates. However, after a stagflation (the situation where high levels of both inflation and unemployment are both experienced) in the 70s, the modern Phillips Curve was derived. It distinguishes between the short-run and long-run relationship between inflation and unemployment. The short-run curved also called the expectations –augmented Phillips curve since it shifts up when inflationary expectations rise. In the long-run, however, the monetary policy cannot affect the unemployment; therefore it can be demonstrated by a vertical line cutting the unemployment line at the natural rate. This is the reason why monetary policy is neutral in the long run or in other words, there’s no trade-off between these two variables in the long run. On the other hand, there’s still fluctuations in the short run and the authority can still temporarily decrease the unemployment by increasing permanent inflation and vice versa. The short-run trade –off in the Phillips curve can be understood through the trade-off between prices and output. In the short-run, there are fluctuations in output levels (upwards sloping Aggregate supply). Suppose a positive Aggregate demand shock moves output above the natural rate and price level above the level people expected. Over time, the expected price level also rises, making the Short run Aggregate...
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