Stabilization policies (fiscal and monetary) are applied to affect inflation and unemployment

The difficulty in stabilization is that inflation and unemployment generally have an inverse relationship

EXAMPLE: If there is economic expansion and there is increased

aggregate demand, then equilibrium price and quantity increase This results in more jobs (to create a higher

output/quantity) Thus, economic expansion that causes inflation is

called demand-pull inflation

13.4 - Inflation & Unemployment

Demand-Pull Inflation

AS

a

b

During expansionary times, aggregate demand increases (shift of aggregate demand curve from AD0 to AD1)Result: price level rises from point a to point bIncreased demand pulls up prices

Real GDP (2002 $ billions)

Under the assumption that there is a fixed and predictable inverse relationship between unemployment and inflation, economist A. W. H. Phillips created a curve which expresses this relationship

The Phillips Curve

Phillips Curve Expresses inverse

relationship between unemployment and inflation

When economy moves from A to B (due to expansionary stabilization policies), inflation increases, unemployment decreases

The Phillips Curve Cont’d

Contractionary policies cause the economy to move from point A to a point right of A

1960 – 1972: inflation and unemployment displayed a trend that clearly followed the shape of a Phillips Curve

1973 – 1982: inflation and unemployment were both higher than in the previous period, so the graph moved up and right Example of STAGFLATION: combination of consistently

low output (expanding unemployment) and rising inflation An increase in input prices decreases a business’s output,

reducing aggregate supply Increased costs push price levels up: Cost-push inflation

1983 – 2010: there was a trend to lower inflation, but unemployment rates stayed high, so there was no clear Phillips Curve

Shifts in the Phillips Curve

Cost-Push Inflation

Increased input prices cause businesses to decrease output Resulting decrease in aggregate supply means a shift in the

aggregate supply curve from AS0 to AS1

Result: price level is pushed up from point d to point c Increased costs push up prices

d

c

In recent years, the Bank has engaged in inflation targeting, a monetary policy program where a central bank keeps annual inflation within a given range Bank of Canada keeps inflation between 1 % and 3 %

Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation

Price Level Targeting: a monetary policy goal of keeping overall price levels stable, or meeting a pre-determined price level target The price level used as a barometer is the Consumer Price

Index (CPI), or some similarly broad measure of cost inputs

Targeting

Economy is able to stabilize itself in the long-run During an economic boom, output may be above the

economy’s potential level Unemployment is low, so workers bargain for higher wages Wage hikes raise business costs, leading to a decrease in

AS Equilibrium moves back to economy’s potential output Unemployment rises to its natural rate

During a recession, output may be below its potential, with a high unemployment rate Unemployment causes a downward pressure on wages Increase in AS boosts output back to potential level Unemployment lowers to its natural rate

Economy’s Self-Stabilizing Tendency

Some economists see little need for government stabilization policy they believe the economy adjusts quickly by itself to

its potential output level Many economists see the self-adjusting process as

a slow one, which means that government stabilization policy can still play an important role in reducing the severity of the ups and downs in the business cycle

Economy’s Self-Stabilizing Tendency