Macroeconomics

❖ Why does fiscal policy known as demand management policy?

Fiscal policy is known as a demand management policy because it involves the use
of government spending and taxation to influence the level of aggregate demand in
the economy. Here's how it works:
How Fiscal Policy Manages Demand
1.Government Spending:
Increase in Spending: When the government increases its spending on infrastructure,
education, healthcare, and other public services, it directly boosts aggregate demand.
This is because government expenditure creates jobs, increases incomes, and, in
turn, raises consumer spending.
Decrease in Spending: Conversely, when the government reduces its spending, it can
lead to a decrease in aggregate demand, potentially cooling down an overheated
economy.
2. Taxation:
Tax Cuts: By reducing taxes, the government increases households' disposable
income, allowing consumers to spend more. This leads to an increase in aggregate
demand.
Tax Hikes: Increasing taxes reduces disposable income, leading to lower consumer
spending and a decrease in aggregate demand.
Goals of Fiscal Policy
Stimulating Economic Growth: During a recession or economic slowdown, the
government can use fiscal policy to increase aggregate demand, thereby stimulating
economic growth and reducing unemployment.
Controlling Inflation: When the economy is overheating and inflation is rising, the
government can reduce aggregate demand through fiscal measures, such as
decreasing public spending or increasing taxes, to keep inflation in check.
Promoting Stability: Fiscal policy aims to smooth out economic cycles by mitigating
the impacts of booms and busts, ensuring a more stable economic environment.
Automatic vs. Discretionary Fiscal Policy
Automatic Stabilizers: These are fiscal mechanisms that automatically adjust
without any deliberate action by policymakers. Examples include unemployment
benefits and progressive taxes that increase or decrease with economic fluctuations.
Discretionary Fiscal Policy: This involves deliberate actions by the government,
such as passing new legislation to increase spending on infrastructure projects or
cutting taxes to boost demand.
By influencing the level of aggregate demand through spending and taxation, fiscal
policy serves as a critical tool for managing economic stability and growth.
❖ Distinguish between Automatic and discretionary fiscal policy.
Automatic Fiscal Policy
Definition: Automatic fiscal policy involves built-in mechanisms that automatically
adjust government spending and taxation in response to economic conditions
without the need for new legislative action.
Examples:
Unemployment Benefits: These increase automatically when unemployment rises,
providing financial support to unemployed workers.
Progressive Income Taxes: Tax revenues automatically decrease when income
levels fall during a recession and increase during economic expansions.
Discretionary Fiscal Policy
Definition: Discretionary fiscal policy involves deliberate actions by the government
to influence economic conditions through changes in government spending and
taxation.
Examples:
Infrastructure Projects: Government decides to fund new infrastructure projects to
stimulate economic growth.
Tax Cuts: Enactment of tax cuts to boost consumer spending and investment.

❖ Discretionary fiscal policy

Purpose
The primary purposes of discretionary fiscal policy are:
Economic Stabilization: To stabilize the economy during periods of recession or
inflation by managing aggregate demand.
Stimulate Growth: To promote economic growth and reduce unemployment during
downturns.
Control Inflation: To curb excessive inflation during periods of economic expansion.
Redistribution of Income: To achieve social objectives by redistributing income
through progressive taxation and welfare programs.
How It Works
Discretionary fiscal policy works through two main mechanisms:
1. Government Spending:
Increasing Spending: The government can inject money into the economy by
funding infrastructure projects, public services, and other initiatives. This boosts
aggregate demand, creating jobs and increasing income.
Decreasing Spending: Reducing government spending can help cool down an
overheated economy, reducing inflationary pressures.
2. Taxation:
Tax Cuts: Lowering taxes increases disposable income for consumers and
businesses, encouraging spending and investment, which boosts aggregate demand.
Tax Hikes: Increasing taxes can reduce disposable income and spending, helping to
control inflation during periods of economic expansion.
Types of discretionary fiscal policy
Expansionary Fiscal Policy
Definition: A policy involving increased government spending and/or decreased
taxes to stimulate economic growth.
In an expansionary fiscal policy, the government decreases tax rates and increases
government spending to stimulate economic growth and employment.
In the above graph, the Real GDP is taken on the horizontal axis (x-axis) while the
price level is taken on the vertical axis (y-axis). The initial equilibrium is at E1 which
is the point of intersection of the aggregate demand curve AD1 and short-run
aggregate supply curve SRAS1. The initial price level is P1 and the initial output
level is Y1. When tax rates are decreased and government spending is increased, the
aggregate demand curve is shifted towards the right from AD1 to AD2. The new
equilibrium point is E1. The real GDP is increased from Y1 to Y2 showing economic
growth and a fall in unemployment. The general price level is increased from P1 to
P2 showing a resulting inflation which is a side-effect of an expansionary fiscal
policy.
The Effects of Expansionary Fiscal Policy on Macroeconomic Objectives
The above graph illustrates the impact of expansionary fiscal policy on the following
macroeconomic objectives of government.
Effect on Economic Growth
Economic growth in a country will increase as a result of using an expansionary
fiscal policy, maybe through a stimulus package. In the above graph, the real GDP
is increased from Y1 to Y2 indicating economic growth.
Effect on Unemployment
Unemployment in a country will decrease as a result of using an expansionary fiscal
policy. In the above graph, the increase in real GDP from Y1 to Y2 indicates a fall
in unemployment.
Effect on Inflation
The inflation rate will increase as a result of using an expansionary fiscal policy. In
the above graph, the increase in price level from P1 to P2 indicates inflation. This is
a negative effect of using an expansionary fiscal policy. The government should keep
an eye on inflation and try to adjust its policies to maintain price stability.
Contractionary Fiscal Policy
Definition: A policy involving decreased government spending and/or increased
taxes to reduce economic growth and control inflation.
In a contractionary fiscal policy, the government increases tax rates and decreases
government spending to control inflation.
In the above graph, the Real GDP is taken on the horizontal axis (x-axis) while the
price level is taken on the vertical axis (y-axis). The initial equilibrium is at E1 which
is the point of intersection of the aggregate demand curve AD1 and short-run
aggregate supply curve SRAS1. The initial price level is P1 and the initial output
level is Y1. When tax rates are increased and government spending is decreased, the
aggregate demand curve is shifted towards the left from AD1 to AD2. The new
equilibrium point is E1. The real GDP is decreased from Y1 to Y2 showing a fall in
output and a rise in unemployment. The general price level is decreased from P1 to
P2 showing a decrease in inflation.
The Effects of Contractionary Fiscal Policy on Macroeconomic Objectives
The above graph illustrates the impact of contractionary fiscal policy on the
following macroeconomic objectives of the government.
Effect on Economic Growth
Economic growth in a country will slow down as a result of using a contractionary
fiscal policy. In the above graph, the real GDP is decreased from Y1 to Y2 indicating
a fall in output level.
Effect on Unemployment
Unemployment in a country will increase as a result of using a contractionary fiscal
policy. In the above graph, the decrease in real GDP from Y1 to Y2 indicates a rise
in unemployment. This is a side-effect of using a contractionary fiscal policy.
Effect on Inflation
The inflation rate will decrease as a result of using a contractionary fiscal policy. In
the above graph, the decrease in the price level from P1 to P2 indicates a slowing
down of inflation.
 ❖ Differences between expansionary and contractionary fiscal policy

❖ Automatic Fiscal Policy

Definition: Automatic fiscal policy refers to built-in mechanisms within the
government’s fiscal framework that automatically adjust spending and taxation in
response to changes in economic conditions without the need for new legislative
action.
Purpose
The primary purpose of automatic fiscal policy is to stabilize the economy by
smoothing out fluctuations in economic activity. It aims to mitigate the effects of
economic cycles by providing automatic counter-cyclical responses to changes in
the economy.
How It Works
Automatic fiscal policies operate based on existing laws and regulations. When
economic conditions change, these built-in mechanisms automatically adjust
government spending and taxation to stabilize the economy. Key components
include:
1. Progressive Income Taxes:
During Economic Expansion: As incomes rise, people move into higher tax brackets,
increasing tax revenue and reducing disposable income, which helps to cool down
the economy.
During Economic Downturn: As incomes fall, people move into lower tax brackets,
decreasing tax revenue and increasing disposable income, which helps to stimulate
the economy.
2. Unemployment Benefits:
During Recession: Unemployment benefits automatically increase as more people
become unemployed, providing financial support and maintaining aggregate
demand.
During Economic Expansion: Unemployment benefits automatically decrease as
more people find jobs, reducing government spending.
3. Welfare Programs: Programs like food stamps and social security adjust based
on economic conditions, providing support during downturns and reducing
expenditure during booms.
❖ How to mitigate inflation?
To mitigate inflation, governments often use contractionary fiscal policy and
monetary policy.
Contractionary Fiscal Policy
Definition: A policy involving decreased government spending and/or increased
taxes.
Purpose: To reduce aggregate demand in the economy, thereby slowing down
economic growth and reducing inflationary pressures.
Monetary Policy
Definition: Actions by a central bank to control the money supply and interest rates.
Purpose: To influence economic activity, with the goal of maintaining price stability.
Raising interest rates makes borrowing more expensive, reducing consumer and
business spending, which helps lower inflation.
Both these policies work by reducing the overall demand in the economy, which
helps to control price rises and stabilize the economy.
Contractionary Fiscal Policy
How It Mitigates Inflation:
Reduced Government Spending: By cutting government expenditures, there is less
money circulating in the economy, which decreases aggregate demand.
Increased Taxes: Raising taxes reduces disposable income for consumers and
businesses, leading to lower spending and investment, thereby reducing aggregate
demand.
Monetary Policy
How It Mitigates Inflation:
Higher Interest Rates: The central bank raises interest rates, making borrowing more
expensive. This discourages spending and investment by consumers and businesses,
which reduces aggregate demand.
Reduced Money Supply: The central bank can also reduce the money supply by
selling government securities or increasing reserve requirements for banks. This
further reduces the amount of money available for spending and investment.
Both these policies aim to reduce overall demand in the economy, which helps to
control price increases and stabilize inflation.
 ❖ Show that BS=TA – G- TR, Where BS= Budget surplus, TA=Taxes,
G=Government spending, TR=Transfer payments.
To derive the relationship BS = TA – G – TR, where BS is the budget surplus, TA is
taxes, G is government spending, and TR is transfer payments, we need to start with
the basic components of the government’s budget.
Government Budget Balance Equation
1. Government Revenue: This primarily comes from taxes.
TA : Total tax revenue collected by the government.
2. Government Expenditure: This includes spending on goods and services, as well
as transfer payments.
G: Government spending on goods and services.
TR: Transfer payments made by the government (e.g., social security,
unemployment benefits).
Budget Surplus
A budget surplus occurs when the government’s revenue exceeds its expenditures.
The equation for the budget surplus BS can be expressed as:
BS = Total Government Revenue - Total Government Expenditure
Given the components above, we can substitute:
BS = TA – (G + TR)
This simplifies to:
BS = TA – G – TR
Summary:
The equation BS = TA – G – TR shows that the budget surplus is equal to the total
tax revenue minus the sum of government spending on goods and services and
transfer payments. It provides a clear and concise way to understand how the budget
surplus is determined based on these key fiscal components.
Budget Deficit
Definition: A budget deficit occurs when government expenditures exceed
government revenues (primarily from taxes) in a given fiscal period.
Budget Deficit= G + TR – TA
Where:
G = Government spending, TR = Transfer payments, TA = Taxes
Balanced Budget
Definition: A balanced budget occurs when government revenues are equal to
government expenditures in a given fiscal period.
Balanced Budget = TA – (G + TR) = 0

❖ Given C=55+0.8Yd, I=90, G= 200, TR=100, t=0.15

i. Calculate the equilibrium level of income and multiplier.
ii. Calculate the budget surplus (BS) .

Equilibrium Level of Income

Definition: The equilibrium level of income is the point where aggregate demand
equals aggregate supply in an economy. At this level, total spending (including
consumption, investment, government spending, and net exports) matches the total
output or income.
How It Works:
The economy reaches equilibrium when planned spending on goods and services
(aggregate demand) equals the total output produced (aggregate supply).
Mathematically, this can be expressed as Y = C + I + G + (X – M) , where Y is the
national income, C is consumption, I is investment, G is government spending, X is
exports, and M is imports.
Multiplier
Definition: The multiplier effect measures how a change in autonomous spending
(like government spending or investment) leads to a larger change in the overall level
of income or output in the economy.
How It Works:
The multiplier effect occurs because an initial increase in spending leads to increased
income for those who receive it, which in turn leads to further spending and income
generation.
Mathematically, the multiplier k is calculated as k = 1 / 1 – MPC(1 – t), where MPC
is the marginal propensity to consume and t is the tax rate.
For example, if the government spends money on building a bridge, the construction
workers who receive this money will spend part of their income on goods and
services, further increasing overall demand and income.
Budget Surplus
Definition: A budget surplus occurs when a government’s total revenues (primarily
from taxes) exceed its total expenditures (including government spending and
transfer payments) in a given fiscal period.
How It Works:
A budget surplus indicates that the government is collecting more money than it is
spending.
Mathematically, the budget surplus BS can be expressed as BS = TA – G – TR ,
where TA is the total tax revenue, G is government spending, and TR is transfer
payments.
A surplus can be used to pay down public debt, save for future expenditures, or invest
in long-term projects.
Summary
Equilibrium Level of Income: The level at which aggregate demand equals aggregate
supply, ensuring all produced output is purchased.
Multiplier: Measures the impact of a change in spending on the overall income,
highlighting the amplification effect in the economy.
Budget Surplus: Occurs when government revenues exceed expenditures, indicating
a net positive balance that can be used for debt reduction or savings.
These concepts are fundamental in understanding how an economy operates and
how fiscal policies can influence economic stability and growth.
Interpreting the Equilibrium Level of Income (1328.125)
Economic Balance:
The equilibrium level of income at 1328.125 units indicates that the total spending
in the economy is perfectly balanced with the total production of goods and services.
In other words, all the output produced by businesses is being purchased by
households, firms, the government, and foreign buyers (if considering net exports).
Interpreting the multiplayer (3.125)
The multiplier we calculated earlier was 3.125. This means that for every unit of
initial spending or investment in the economy, the total income or output increases
by 3.125 units.
❖ Define Aggregate demand. Why does aggregate supply curve upward
slopping?
Aggregate Demand
Definition: Aggregate demand (AD) is the total demand for goods and services in
an economy at a given overall price level and in a given period. It represents the sum
of all consumption, investment, government spending, and net exports (exports
minus imports).
Components of Aggregate Demand:
1. Consumption (C): Spending by households on goods and services.
2. Investment (I): Spending by businesses on capital goods like machinery,
buildings, and inventories.
3. Government Spending (G): Expenditures by the government on goods and
services.
4. Net Exports (X – M): Exports (X) minus imports (M), representing foreign
demand for the country’s goods and services.
Equation:
AD = C + I + G + (X – M)

Aggregate Supply
Definition: Aggregate supply (AS) refers to the total quantity of goods and services
that producers in an economy are willing and able to supply at a given overall price
level, in a given period. It reflects the economy’s capacity to produce goods and
services.
Components of Aggregate Supply
1.Short-Run Aggregate Supply (SRAS):
Description: The short-run aggregate supply curve is upward sloping because, in the
short run, prices of goods and services can change, but wages and input prices tend
to be sticky or slow to adjust.
Factors Affecting SRAS:
Production Costs: Changes in wages, raw materials, and energy costs.
Supply Shocks: Unexpected events like natural disasters or geopolitical events.
Expectations of Future Prices: How producers expect future price levels to change.
2.Long-Run Aggregate Supply (LRAS):
Description: The long-run aggregate supply curve is vertical at the economy’s
potential output level (full-employment output). In the long run, all prices, including
wages and input prices, are flexible.
Factors Affecting LRAS:
Technology: Improvements in technology that increase productivity.
Labor Force: Growth or changes in the labor force.
Capital Stock: Investment in capital goods like machinery and infrastructure.
Institutional Factors: Efficiency of institutions, such as legal and regulatory
frameworks.
❖ Why Is the Short-Run Aggregate Supply Curve Upward Sloping?
1. Sticky Wages and Prices:
Wages: In the short run, wages are often slow to adjust to changes in economic
conditions. If the price level rises, wages may not increase immediately, leading to
higher profits for firms and encouraging them to produce more.
Prices: Some prices of goods and services are also sticky and do not adjust
immediately to changes in the price level. As the overall price level increases, firms
can increase production to take advantage of higher prices and profits.
2. Misconceptions About Relative Prices:
Firms and workers may mistake changes in the overall price level for changes in
relative prices. For example, if the price level increases, firms might interpret this as
a higher demand for their specific products and increase production accordingly.
3. Menu Costs:
The costs associated with changing prices (menu costs) can lead to firms adjusting
their prices infrequently. When the overall price level increases, firms may
temporarily produce more before adjusting their prices.
4. Profit Margins:
As the overall price level rises, firms’ revenues increase more quickly than their
costs (such as wages and input prices), leading to higher profit margins. This
incentivizes firms to increase production.
Why Is the Long-Run Aggregate Supply Curve Vertical?
1. Full Employment:
In the long run, the economy operates at full employment, where all available
resources are fully utilized. The output is determined by the economy’s productive
capacity, not by the price level.
2. Flexible Prices and Wages:
In the long run, prices and wages are fully flexible and can adjust to changes in
economic conditions. This flexibility ensures that the economy returns to its
potential output even after short-term fluctuations.
Summary
Aggregate Supply (AS): Represents the total quantity of goods and services that
producers in an economy are willing to supply at different price levels.
Short-Run Aggregate Supply (SRAS): Upward sloping due to sticky wages and
prices, and misinterpretation of price signals.
Long-Run Aggregate Supply (LRAS): Vertical at potential output, reflecting full
employment and flexibility of prices and wages.
 ❖ Draw a Keynesian supply curve and explain it.
Keynesians: Supporters of the economist John Maynard Keynes who believe that
the government intervention is necessary for an economy to reach at the full
employment level.
A Keynesian aggregate supply curve is typically depicted as a horizontal line at low
levels of output, then sharply transitioning to a vertical line at full employment,
creating an “L” shape, signifying that firms can easily increase production at low
output levels due to readily available spare capacity, but face significant constraints
once the economy reaches full employment and cannot produce more without
significant price increases; this reflects the Keynesian idea of “sticky wages” and
prices, where firms are reluctant to change prices rapidly, especially during
economic downturns.
Keynesians represent the long-run aggregate supply curve as perfectly elastic at low
output, then upward sloping over a range of output and finally perfectly inelastic at
the full employment level of output. This is to emphasize their point that, in the long
run, an economy can operate at any output level and not necessarily at the full
employment level.

In the diagram, the LRAS is perfectly elastic (horizontal) if the economy has high
unemployment of resources (before Y1). More output can be produced without an
increase in costs of production and the price level, P1. At low output, firms can
attract more resources without bidding up their prices. For example, at high
unemployment, only the job offer may be enough to attract new workers.
The LRAS becomes more inelastic (upward sloping) as the economy approaches full
employment output, between Y1 and Yf. The upward slope shows that the firms
begin to face shortages of inputs and bid up wages, raw material prices and the price
of capital equipment. Costs of firms will increase and, as a result, the price level will
also increase.
The LRAS becomes perfectly inelastic (vertical) at Yf which is the full employment
output (potential output), since at this point a further increase in the output is not
possible. At Yf the economy is producing the maximum output it can make with the
existing resources. This can also be shown by the points on the production possibility
curve (PPC).
The flat portion of the curve to the left is the short-run aggregate supply (SRAS). In
this zone, changes in aggregate demand (AD) affect output but have little impact on
prices. The short-run aggregate supply (SRAS) is flat because Keynes believed that
prices do not change in the short run.
❖ What can cause aggregate demand to rise and what can cause it to fall?
Aggregate demand can rise due to increases in consumer spending, business
investment, government spending, and net exports (exports minus imports), while it
can fall when any of these components decrease; essentially, positive economic
factors like increased consumer confidence or government stimulus programs can
boost aggregate demand, whereas negative factors like a recession or decreased
consumer wealth can cause it to decline.
Factors that increase aggregate demand:
Increased consumer spending:
When people have more disposable income or feel optimistic about the economy,
they tend to spend more, leading to higher aggregate demand.
Higher business investment:
If businesses are confident about future economic growth, they are more likely to
invest in new equipment and facilities, which boosts aggregate demand.
Increased government spending:
Government initiatives like infrastructure projects or stimulus packages can directly
increase aggregate demand by injecting more money into the economy.
Increased net exports:
When a country exports more goods than it imports, this positively impacts
aggregate demand.
Factors that decrease aggregate demand:
Decreased consumer spending:
Factors like high unemployment, falling wages, or decreased consumer confidence
can lead to reduced consumer spending, lowering aggregate demand.
Lower business investment:
If businesses are pessimistic about the economy, they may reduce investment,
impacting aggregate demand negatively.
Reduced government spending:
Cuts in government programs or austerity measures can lead to a decrease in
aggregate demand.
Decreased net exports:
If a country imports more than it exports, this can negatively affect aggregate
demand.
❖ Illegal goods and services are not counted in GDP. Explain it.
Illegal goods and services are not counted in GDP because the calculation of GDP
relies on officially recorded economic activity, and by definition, illegal activities
are not reported to authorities, making it impossible to accurately measure their
economic value and include them in the calculation.
Key points to remember:
Data Availability:
Since illegal activities are hidden from official records, there is no reliable data to
include them in GDP calculations.
Concept of GDP:
GDP measures the total market value of all final goods and services produced within
a country in a given period, and this definition inherently excludes illegal activities.
Distortion of Economic Picture:
Including illegal activities in GDP could distort the true picture of a country’s
economic health, as it would be difficult to accurately assess the size and impact of
such activities.
Examples of illegal activities not included in GDP:
Drug trafficking, Prostitution, Smuggling, and Unlicensed gambling.
❖ Distinguish between GDP deflator and CPI.
The GDP deflator is a measure of the price level of all goods and services in an
economy, while the Consumer Price Index (CPI) is a measure of the price level of
goods and services purchased by consumers.
The Consumer Price Index (CPI) and the GDP deflator are both measures of inflation
in an economy, but they differ in what they measure and how they are calculated.
What they measure
CPI: Measures price changes in goods and services purchased by consumers.
GDP deflator: Measures price changes in all goods and services produced in a
country, including those purchased by consumers, businesses, the government, and
foreigners.
How they are calculated
CPI
Based on a fixed basket of goods and services that an average person buys yearly.
GDP deflator
Based on a changing set of commodities and dynamically adjusts to shifts in
consumption patterns and production trends.
Why they are different
The CPI includes imported goods, while the GDP deflator does not.
The CPI only measures consumer goods, while the GDP deflator measures all goods
and services.
Why the GDP deflator is preferred
The GDP deflator is generally preferred over the CPI for measuring inflation because
it provides a broader and more accurate analysis.
 ❖ Philips curve
Short-Run Phillips Curve: Downward Sloping
Reason for Downward Slope: The short-run Phillips curve shows an inverse
relationship between inflation and unemployment. Here are the reasons why it is
downward sloping:
1. Wage and Price Stickiness:
- In the short run, wages and prices are not fully flexible. When unemployment is
low, there is upward pressure on wages because firms compete for scarce labor. This
leads to higher production costs, which firms pass on to consumers in the form of
higher prices, resulting in inflation.
- Conversely, when unemployment is high, there is less upward pressure on wages,
keeping production costs and prices stable or even falling, leading to lower inflation.
2. Expectations of Inflation:
- Workers and firms form expectations about future inflation based on current and
past inflation rates. If they expect higher inflation, they demand higher wages, which
firms pass on as higher prices. This can lead to a temporary trade-off between
inflation and unemployment as firms adjust to new wage agreements and production
costs.
3. Demand-Pull Inflation:
- When aggregate demand in the economy increases, it leads to higher demand for
goods and services. To meet this increased demand, firms hire more workers,
reducing unemployment. The increased demand also leads to higher prices, resulting
in inflation. Thus, lower unemployment is associated with higher inflation in the
short run.
Long-Run Phillips Curve: Vertical
Reason for Vertical Shape: The long-run Phillips curve is vertical, indicating that
there is no trade-off between inflation and unemployment in the long run. Here are
the reasons why it is vertical:
1. Natural Rate of Unemployment (NAIRU):
- In the long run, the economy tends to return to its natural rate of unemployment,
also known as the non-accelerating inflation rate of unemployment (NAIRU). This
rate is determined by structural factors such as labor market policies, technology,
and workforce demographics.
- Regardless of the inflation rate, unemployment will always return to the natural
rate in the long run. This means that any attempt to reduce unemployment below the
natural rate by increasing aggregate demand will only lead to higher inflation
without affecting the long-term unemployment rate.
2. Full Flexibility of Wages and Prices:
- In the long run, wages and prices are fully flexible and can adjust to changes in
economic conditions. This flexibility ensures that the economy returns to its
potential output and natural rate of unemployment, regardless of the inflation rate.
- As wages and prices adjust, any initial trade-off between inflation and
unemployment disappears, resulting in a vertical Phillips curve.
3. Expectations and Adaptation:
- Over time, workers and firms adjust their expectations about inflation based on
actual experiences. As they adapt to higher inflation, they demand higher wages,
which leads to a self-perpetuating cycle of wage and price increases without any
impact on long-term unemployment.
- This adjustment process ensures that in the long run, the economy operates at the
natural rate of unemployment, and any increase in aggregate demand only results in
higher inflation without reducing unemployment.
Summary
The short-run Phillips curve is downward sloping due to wage and price stickiness,
inflation expectations, and demand-pull inflation, which create a temporary trade-
off between inflation and unemployment. The long-run Phillips curve is vertical
because the economy returns to its natural rate of unemployment, with fully flexible
wages and prices and no long-term trade-off between inflation and unemployment.