BU.220.610 Chap.7 The Phillips Curve, Unemployment and Monetary Policy
The Phillips Curve, Unemployment and Monetary Policy
Module 7 takes the final steps toward understanding how the Federal Reserve pursues the goals Congress gives it: price stability, read as 2% annual inflation, and maximum employment, understood as unemployment near a natural rate currently put at about 3 to 4%. Doing so needs a more realistic short-run supply curve than the flat one of Module 5 or the vertical one of the long run.
The chapter builds that curve from the sticky-price model. Firms with some pricing power would like to set their own price above the average when the economy is running hot and below it when it is slack. Some firms, however, must set prices in advance, because of long contracts, the cost of changing posted prices or a wish not to unsettle customers, and they can only use the price level they expect.
Averaging the two groups gives a price level that sits above its expected value by an amount proportional to the output gap. Inverted, it says output exceeds potential only when prices turn out higher than expected, which gives an upward-sloping short-run supply curve that shifts up whenever expectations rise.
An imperfect-information story, in which producers mistake economy-wide price changes for changes in their own relative price, reaches the same curve and is treated descriptively. The second step translates that curve into the numbers in the news. Okun's law links output to unemployment: as a rule of thumb, real GDP grows about 3% a year when unemployment is steady and about 2 points less for each point unemployment rises.
Substituting it into short-run supply gives the Phillips curve, in which inflation depends on expected inflation, on cyclical unemployment with a negative sign, and on supply shocks. Demand-pull inflation arises when strong demand pushes unemployment below its natural rate; cost-push inflation arises from supply shocks.
With adaptive expectations, last year's inflation shapes this year's, so inflation has inertia and reducing it costs output, measured by the sacrifice ratio. If expectations are rational and the central bank is credible, that cost can be much smaller.
The natural rate itself reflects how labor markets work, including wage rigidities and imperfect competition, which helps explain why it has been higher in much of Europe than in the United States. The module ends by applying the full toolkit to the COVID-19 pandemic, a downturn in which both spending and productive capacity fell at once, and to the inflation that followed, a legacy the Fed is still managing.
What this chapter covers
- 01
The sticky-price model of short-run supply
- 02
Expected prices and the output gap
- 03
Okun's law
- 04
The Phillips curve and inflation expectations
- 05
Disinflation and the sacrifice ratio
- 06
The Fed's mandate and the COVID-19 shock
Worked example · free
Use Okun's law and the Phillips curve on a hot labor market
- 1Compute cyclical unemployment: 3.5 minus 4.5 = minus 1 point.
- 2Apply the Phillips curve: inflation = 2.5 minus 0.4 times (minus 1) = 2.9%.
- 2Apply the Okun rule of thumb: growth = 3 minus 2 times (minus 1) = about 5%.
Key terms
- Sticky-Price Model
- A model of short-run supply in which some firms set prices in advance at the expected price level, so output rises when prices exceed expectations.
- Okun's Law
- The empirical rule that output growth falls about two points below its normal rate for each one-point rise in unemployment.
- Natural Rate of Unemployment
- The unemployment rate consistent with output at potential and stable inflation, shaped by how the labor market works.
- Sacrifice Ratio
- The percentage of a year's real GDP lost to reduce inflation by one percentage point; a typical textbook estimate is 5.
The Phillips Curve, Unemployment and Monetary Policy FAQ
Why does the short-run supply curve slope upward?
Firms that set prices in advance use the price level they expect. When demand pushes actual prices above that expectation, flexible-price firms raise prices while the others hold theirs, and output rises above potential until expectations catch up.
Can the Fed permanently lower unemployment by accepting higher inflation?
Not in this framework. The trade-off holds only while expectations are fixed. Once people expect the higher inflation, the Phillips curve shifts up and unemployment returns to its natural rate with inflation left higher.
What made the 2020 recession different from a normal downturn?
Shutdowns cut both spending and the economy's capacity to produce, so aggregate demand and long-run supply shifted left together. Output fell without the usual spare capacity, and relief rather than stimulus was the main aim of fiscal policy.
How do expectations change the cost of bringing inflation down?
With adaptive expectations, inflation falls only after unemployment rises above its natural rate, which costs output. If a credible central bank can lower expected inflation directly, inflation can fall with a much smaller rise in unemployment.
Exam move
Memorise the two equations as one chain, from unemployment through Okun's law to output and through the Phillips curve to inflation, and practise both directions of each. Then write a half-page note on the COVID-19 case in AD-AS terms, since the module's group assignment and discussion both apply the toolkit to it.
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