The four possible relationships between real wages and unemployment

Learning Objectives Review the historical evidence regarding the theory of the Phillips curve Key Takeaways Key Points The relationship between inflation rates and unemployment rates is inverse.

long run phillips curve

Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and unemployment in the short-run. According to rational expectations, attempts to reduce unemployment will only result in higher inflation.

Key Terms adaptive expectations theory: A hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate.

Shifting the Phillips Curve The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment and high inflation. Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run led to higher inflation and no change in unemployment in the long run.

There are two theories that explain how individuals predict future events.

how does inflation affect unemployment

The typical worker received less than one half of one percent annual increase in real wages since the s. The Phillips curve depicts the relationship between inflation and unemployment rates.

Short run and long run phillips curve pdf

These two factors are captured as equivalent movements along the Phillips curve from points A to D. As one increases, the other must decrease. Friedman's and Phelps' findings gave rise to the distinction between the short-run and long-run Phillips curves. Anything that is nominal is a stated aspect. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. If inflation was higher than normal in the past, people will take that into consideration, along with current economic indicators, to anticipate its future performance. In a scenario wherein monetary or fiscal policies are adopted to lower unemployment below the natural rate, the resultant increase in demand will encourage firms and producers to raise prices even faster. The claim is weak, though.

One reason is about measurement; the second reason is about power. This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation.

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Why Wages Won't Rise When Unemployment Falls