IS-LM Model PDF

IS-LM MODEL SESSION 11 PROF. ANKITA DASH Source: Google photos 1  THE IS CURVE The IS curve (“Investment-Savings” curve) shows combinations of interest rates and levels of output such that planned spending equals income We can also derive the IS curve usi...

IS-LM MODEL SESSION 11 PROF. ANKITA DASH Source: Google photos 1  THE IS CURVE The IS curve (“Investment-Savings” curve) shows combinations of interest rates and levels of output such that planned spending equals income We can also derive the IS curve using the goods market equilibrium condition: Y = AD = A + c(1 − t )Y − bi  Y − c(1 − t )Y = A − bi Y (1 − c(1 − t )) = A − bi Y = G ( A − bi ) 1 where G = (1 − c(1 − t )) is the Government multiplier THE IS CURVE  THE LM CURVE The LM schedule shows all combinations of interest rates and levels of income such that the money market is in equilibrium The LM curve can be obtained directly by combining the demand curve for real balances and the fixed supply of real balances – For the money market to be in equilibrium, supply must equal demand: M = kY − hi P – Solving for i: 1 M i =  kY −  h P THE LM CURVE GOODS MARKET AND MONEY MARKET EQUILIBRIUM  EQUILIBRIUM - THE GOODS AND MONEY MARKET The IS and LM schedules summarize the conditions that have to be satisfied for the goods and money markets to the in equilibrium Assumptions: Price level is constant Firms willing to supply whatever amount of output is demanded at that price level EQUILIBRIUM - THE GOODS AND MONEY MARKET  CHANGES IN THE EQUILIBRIUM LEVELS OF INCOME AND THE INTEREST RATE The equilibrium levels of income and the interest rate change when either the IS or the LM curve shifts Figure shows effects of an increase in autonomous spending – Shifts IS curve out by  G I if autonomous investment is the source of increased spending – The resulting change in Y is smaller than the change in autonomous spending due to slope of LM curve CHANGES IN THE EQUILIBRIUM LEVELS OF INCOME AND THE INTEREST RATE  DERIVING THE AD SCHEDULE The AD schedule maps out the IS-LM equilibrium holding autonomous spending ( 𝐴)ҧ and the nominal money supply ( 𝑀) ഥ constant and allowing prices (P) to vary Suppose prices increase from 𝑃1 to 𝑃2 𝑀ഥ 𝑀ഥ – decreases to → LM decreases from 𝐿𝑀1 to 𝐿𝑀2 𝑃1 𝑃2 – Interest rates increase from 𝑖1 to 𝑖2 , and output falls from 𝑌1 to 𝑌2 => Corresponds to lower AD DERIVING THE AD SCHEDULE  DERIVING THE AD SCHEDULE Derive the equation for the AD curve using the equations for the IS-LM curves: IS : Y = G ( A − bi ) 1 M LM : i =  kY −  h P  Substituting LM equation into the IS equation:  b M  Y =  G  A −  kY −   h P  h G b G M = A+ h + kb G h + kb G P bM = A +  h P  DERIVING THE AD SCHEDULE hG bG M Y= A+ h + kbG h + kbG P The above equation is the AD (Aggregate Demand) schedule – It summarizes the IS-LM relation, relating Y and P for given levels of autonomous spending and nominal balances – Since P is in the denominator, AD is downward sloping The above equation shows that AD depends directly upon: 1. Autonomous spending 2. Real money stock Equilibrium income is higher with: – higher level of autonomous spending – higher stock of real balances of money Source: Google photos 15 AGGREGATE DEMAND AND SUPPLY SESSION 12 PROF. ANKITA DASH Source: Cartoonstock 1 AGGREGATE DEMAND  DERIVING THE AD SCHEDULE The AD schedule maps out the IS-LM equilibrium holding autonomous spending ( 𝐴)ҧ and the nominal money supply ( 𝑀) ഥ constant and allowing prices (P) to vary Suppose prices increase from 𝑃1 to 𝑃2 𝑀ഥ 𝑀ഥ – decreases to → LM decreases from 𝐿𝑀1 to 𝐿𝑀2 𝑃1 𝑃2 – Interest rates increase from 𝑖1 to 𝑖2 , and output falls from 𝑌1 to 𝑌2 => Corresponds to lower AD DERIVING THE AD SCHEDULE  DERIVING THE AD SCHEDULE Derive the equation for the AD curve using the equations for the IS-LM curves: IS : Y = G ( A − bi ) 1 M LM : i =  kY −  h P  Substituting LM equation into the IS equation:  b M  Y =  G  A −  kY −   h P  h G b G M = A+ h + kb G h + kb G P bM = A +  h P  DERIVING THE AD SCHEDULE hG bG M Y= A+ h + kbG h + kbG P The above equation is the AD (Aggregate Demand) schedule – It summarizes the IS-LM relation, relating Y and P for given levels of autonomous spending and nominal balances – Since P is in the denominator, AD is downward sloping The above equation shows that AD depends directly upon: 1. Autonomous spending 2. Real money stock Equilibrium income is higher (AD shifts right) with : – higher level of autonomous spending (expansionary Fiscal Policy) – higher stock of real balances of money (expansionary Monetary Policy)  DERIVING THE AD SCHEDULE hG bG M Y= A+ h + kbG h + kbG P The slope of the AD curve depends on- – b : when interest sensitivity of Investment (b) is higher, then for a fall in price level P, there would be a greater effect on investment due to fall in interest rate, i. -→ AD will be flatter – h : when interest sensitivity of money demand (h) is higher, LM curve is flatter. A smaller change in interest occurs due to change in prices; this smaller change in i has a smaller impact on I (which in turn has a smaller impact on Y) -→ AD is steeper – αG : when multiplier is higher, for a fall in price level P, interest rate i would fall resulting in higher I and Y → AD will be flatter AD represents the Quantity Theory of Money equation : MV = PY AGGREGATE SUPPLY  MACROECONOMICS IN THREE MODELS The study of macroeconomics is grounded in three models, each appropriate for a particular time period 1. Long Run (Very Long Run Model): Domain of growth theory – focuses on growth of the production capacity of the economy 2. Medium Run (Long Run Model): a snapshot of the very long run model, in which capital and technology are largely fixed Level of capital & technology determine level of potential output Output is fixed, but prices determined by changes in AD 3. Short Run Model: Business Cycle theories Changes in AD determine how much of the productive capacity is used and the level of output and unemployment Prices are fixed in this period, but output is variable  VERY LONG RUN GROWTH Growth theory examines how the accumulation of inputs and improvements in technology lead to increased standards of living Rate of saving is a significant determinant of future well being and economic growth.  THE LONG RUN MODEL In the long run, the AS curve is vertical and pegged at the potential level of output – Output is determined by the supply side of the economy and its productive capacity – The price level is determined by the level of demand relative to the productive capacity of the economy Economy is at full employment Conclusion: High rates of inflation are always due to changes in AD in the long run  THE SHORT RUN MODEL The AS curve is flat in the short run due to fixed/rigid prices, so changes in output are due to changes in AD Sticky prices are attributed to rigidities in the factor markets – especially the labour market In the short run, AD determines output, and unemployment; thus constitutes phases of the business cycles  THE MEDIUM RUN The medium run AS curve is tilting upwards towards the long run AS curve position When AD pushes output above the sustainable levels at fixed prices, firms have to increase their output prices Rising prices adjust through the factor markets, especially labour market.  AGGREGATE SUPPLY Aggregate Supply (AS) is the relationship between the overall price level in the economy and the amount of output that will be supplied. – As output goes up, prices will be higher. Why does output go up with prices? – In fact, if all prices and costs went up by the same amount, then the desired level of output would not change. – But many economists believe that wages adjust slowly to prices, at least in the short run. – So higher prices of output will reduce the real wage, which is defined as the ratio of average wages to average prices – This in turn will reduce the cost to firms of increasing output, and hence output will rise.  AGGREGATE SUPPLY Further develop the AS side of the economy; the dynamic adjustment process from the short run to the long run – The price-output relationship is based upon links between wages, prices, employment, and output → link between unemployment and inflation = Phillips Curve – Translate between unemployment and output, inflation and price changes NOTE: theory of AS is the least settled area in macro – Don’t fully understand why W and P are slow to adjust, but offer several theories – All modern models differ in starting point, but reach the same conclusion: SRAS is flat, LRAS is vertical  PRICE STICKINESS The key question in the theory of AS is “Why do the nominal prices adjust slowly to shifts in demand?” OR “Why are prices sticky in the short run?” Since wages are a major component of the overall cost of doing business, wage stickiness may lead to output price stickiness. – Wages are bound by contracts and may not be revised frequently – Unions centralize the wage bargaining – With inflation indexing, downward revision of wages is not possible – Minimum wages can add to wage rigidity At least some firms can adopt a “wait and see” attitude before adjusting their prices or wages There are adjustment costs associated with changing prices. – firms must print new price lists and catalogs, and notify customers of price change → doing this too often could jeopardize customer relations Firms may have explicit long-term contracts to sell their products to other firms at specified prices  SHIFTS IN AGGREGATE SUPPLY AS depends directly upon: 1. Factors of production 2. Technology Equilibrium income is higher (AS shifts right) with : – Lower prices of factors of production, – Higher the quantities of factors of production available – Improvement of technology EQUILIBRIUM IN THE ECONOMY  AGGREGATE DEMAND AND SUPPLY The intersection of the economy’s aggregate demand and short-run aggregate supply curves determines equilibrium real GDP and price level in the short run The intersection of aggregate demand and long-run aggregate supply determines its long-run equilibrium Source: Google photos 20 UNEMPLOYMENT SESSION 13 PROF. ANKITA DASH Source: Cartoonstock 1  UNEMPLOYMENT AND OUTPUT Unemployment and output are tightly linked – but the link is not perfect Unemployment is a lagging economic indicator – Can be a mistaken guide to policy – Rising GDP may be of little solace to those still without a job Costs of unemployment not equally distributed Unemployment may be defined as “a situation in which the person is capable of working both physically and mentally at the existing wage rate but does not get a job to work”. 𝐽𝑜𝑏 𝑠𝑒𝑒𝑘𝑒𝑟𝑠 𝑤𝑖𝑡ℎ𝑜𝑢𝑡 𝑎 𝑗𝑜𝑏 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 = × 100 𝑇𝑜𝑡𝑎𝑙 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒  THE UNEMPLOYMENT POOL At any point in time there is a given number (pool) of unemployed people There are flows in and out of the unemployment pool. A person can become unemployed for one of four reasons: 1. He/she may be a new entrant or re-entrant into the Labour Force (LF) 2. The person may quit a job in order to look for other employment and may register as unemployed while searching 3. The person may be laid off 4. The worker may lose a job when the firm closes There are three ways of moving out of the unemployment pool: 1. A person may be hired into a new job 2. Someone laid off may be recalled 3. An unemployed person may stop looking for a job, and thus move out of the labor force  TYPES OF UNEMPLOYMENT Frictional Unemployment is the unemployment that exists when the economy is at full employment; as workers choose to move from one job to another, a temporary period of unemployment is created – Results from the structure of the labor market, including: ▪ New Entrants Into Labor Market ▪ Search for Greater Meaning ▪ Looking for New/Better Jobs ▪ Immobility of labour, ▪ Lack of correct and timely information, ▪ Unemployment Benefits Structural unemployment arises due to drastic changes in the economic structure of a country that affect either the supply of a factor or demand for a factor of production. – arises from the mismatch between the jobs available in the market and the skills of the available workers in the market. – E.g. the result of certain changes in the techniques of production which may not warrant much labour like Automation, AI Frictional + Structural unemployment rate = natural rate of unemployment  TYPES OF UNEMPLOYMENT Cyclical unemployment is unemployment in excess of frictional unemployment – Occurs when output is below the full employment level – The presence of cyclical unemployment indicates a downturn in the economy – Caused by trade cycles at regular intervals. – Cyclical unemployment is normally a shot-run phenomenon. Open Unemployment: – Situation where in a large section of the labour force does not get a job that may yield them regular income. – The labour force expands at a faster rate than the growth rate of economy. – Hence all people do not get jobs. Disguised Unemployment: – Situation in which more people are doing work than actually required. – Even if some are withdrawn, production does not suffer. – Example: Overcrowding in agriculture due to rapid growth of population and lack of alternative job opportunities may be cited as the main reasons for disguised unemployment in India.  TYPES OF UNEMPLOYMENT Seasonal Unemployment – Unemployment during certain seasons of the year – In some industries and occupations like agriculture, holiday resorts, ice factories etc., production activities take place only in some seasons. – People engaged in such type of activities may remain unemployed during the off- season. Casual Unemployment: – When a person is employed on a day-to-day basis, casual unemployment may occur due to short-term contracts, shortage of raw materials, fall in demand, change of ownership etc.  THE WAGE-UNEMPLOYMENT RELATIONSHIP AND STICKY WAGES In neoclassical theory of supply, wages adjust instantly to ensure that output always at the full employment level, But output is NOT always at the full employment level, and the PC suggests that wages adjust slowly in response to changes in unemployment The key question in the theory of AS is “Why does the nominal wage adjust slowly to shifts in demand?” OR “Why are wages sticky?” Wages are sticky when wages move slowly over time, rather than being flexible, allowing for economy to deviate from the full employment level  THE WAGE-UNEMPLOYMENT RELATIONSHIP AND STICKY WAGES Explanation of wage stickiness builds upon mentioned theories and one central element → the labor market involves long-term relationships between firms and workers → Working conditions, including the wage, are renegotiated periodically, but not frequently, due to the costs of doing so At any time, firms and workers agree on a wage schedule to be paid to currently employed workers – If demand for labor increases and firms increase hours of work, in the SR wages rise along a curve – With demand up, workers press for increased wages, but takes time to renegotiate all wages (staggered wage-setting dates) – During the adjustment process, firms also resetting P to cover increased cost of production Process of W and P adjustment continues until economy back at full employment level of output  UNEMPLOYMENT IN INDIA National Sample Survey Office (NSSO), an organization under Ministry of Statistics and Programme Implementation (MoSPI) measures unemployment It defines employment and unemployment on the following activity statuses of an individual: – Working (engaged in an economic activity) i.e. 'Employed'. – Seeking or available for work i.e. 'Unemployed'. – Neither seeking nor available for work. The first two constitutes labour force and unemployment rate is the percent of the labour force that is without work. 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝑊𝑜𝑟𝑘𝑒𝑟𝑠 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 = × 100 𝑇𝑜𝑡𝑎𝑙 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒 Employed person is one who during the reference week: 1. Did at least one hour of work for pay in the last week 2. Worked at least 15 hours as an unpaid worker for an enterprise owned by a family member OR 3. Was not working, but only temporarily absent from work (ex. vacation or maturity leave)  UNEMPLOYMENT IN INDIA National Sample Survey Organization (NSSO) measures unemployment in India on following approaches: Usual Status Approach: This approach estimates only those persons as unemployed who had no gainful work for a major time during the 365 days preceding the date of survey. Weekly Status Approach: This approach records only those persons as unemployed who did not have gainful work even for an hour on any day of the week preceding the date of survey. Daily Status Approach: Under this approach, unemployment status of a person is measured for each day in a reference week. A person having no gainful work even for 1 hour in a day is described as unemployed for that day.  UNEMPLOYMENT IN INDIA Year Unemployment Rate (percent) 9.2 (June 2024) 2024 8.003 2023 2022 7.33 2021 5.98 2020 8.00 2019 5.27 2018 5.33 2017 5.36 2016 5.42 2015 5.44 https://www.business- standard.com/article/economy- 2014 5.44 policy/unemployment-rate- 2013 5.42 rises-to-7-8-in-june-with-loss- 2012 5.41 of-13-mn-jobs-cmie- 122070500959_1.html 2011 5.43 2010 5.55 2009 5.54 2008 5.41  THE PHILLIPS CURVE Prices tend to adjust slowly → AD drives the economy in the meantime The speed of price adjustment is illustrated by the Phillips curve, which plots the inflation rate against the unemployment rate Derivation  THE PHILLIPS CURVE Prices tend to adjust slowly → AD drives the economy in the meantime The speed of price adjustment is illustrated by the Phillips curve, which plots the inflation rate against the unemployment rate In the short run, AS curve is relatively flat, and movements in AD drive changes in prices, output, and unemployment  AGGREGATE DEMAND AND SUPPLY The intersection of the economy’s aggregate demand and short-run aggregate supply curves determines equilibrium real GDP and price level in the short run The intersection of aggregate demand and long-run aggregate supply determines its long-run equilibrium  UNEMPLOYMENT CASE I: Recessionary Gap 𝑌0 < 𝑌 ∗ Unemployment exists as resources are underutilized Workers are willing to work for less wages as they want jobs → wages negotiation takes place Downward pressure on wages, w and prices, P CASE II: Inflationary Gap 𝑌0 > 𝑌 ∗ Overemployment exists as resources are overutilized Shortage of labour → Workers have to be paid more wages for overtime → wages negotiation takes place Upward pressure on wages, w and prices, P MAJOR CAUSES OF UNEMPLOYMENT IN INDIA Large population Low or no educational levels and vocational skills of working population Inadequate state support, legal complexities and low infrastructural, financial and market linkages to small/ cottage industries or small businesses, making such enterprises unviable with cost and compliance overruns. Huge workforce associated with informal sector due to lack of required education/ skills, which is not captured in any employment data. – For ex: domestic helpers, construction workers etc. The syllabus taught in schools and colleges, being not as per the current requirements of the industries. Inadequate growth of infrastructure and low investments in manufacturing sector, hence restricting employment potential of secondary sector. Low productivity in agriculture sector combined with lack of alternative opportunities for agricultural worker which makes transition from primary to secondary and tertiary sectors difficult. Regressive social norms that deter women from taking/continuing employment.  THE COSTS OF UNEMPLOYMENT Costs of Cyclical unemployment: ▪ Okun’s law tells us that every 1 point increase in unemployment reduces output by 2% points ▪ Distributional impact of unemployment may be more dire for some groups than others (Ex. Teenagers vs. older workers) ▪ In addition to lost output from unemployment, there is reduced tax revenues Social costs of unemployment: ▪ problem of poverty ▪ increase in crime in the country. ▪ Include increased divorce rates, suicide rates, and depression ▪ Loss in valuable human resources  INFLATION SESSION 14 PROF. ANKITA DASH Source: Cartoonstock 1  INFLATION Inflation: Rate of change of general price levels in an economy over a given period of time 𝑃𝑡 − 𝑃𝑡−1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 , 𝜋 = 𝑃𝑡−1 Where 𝑃𝑡 = Price levels in the current period 𝑃𝑡−1 = Price levels in the past period Different modes of inflation : – Creeping Inflation – Galloping Inflation – Hyperinflation – Stagflation – Deflation 2 Measured using a price index  PRICE INDEX Price index: a measure of how the price level has risen from one year to the next. GDP Deflator : Ratio of the nominal GDP to real GDP in a given year 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = 𝑥 100 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 Measures the change in prices between the base year and the current year Is based on all goods and services produced in the economy – widely based index 3  PRICE INDEX Consumer Price Index (CPI) : Measures the cost of buying a representative basket of goods and services σ 𝐶𝑡 𝐶𝑃𝐼𝑡 = 𝑥 100 σ 𝐶0 Weighted index for each product or service in proportion to its share of recent consumer spending Factors in the substitution effect as consumers shift spending away from the products rising in price on a relative basis. Also adjusts for changes in product quality and features 4  CONSUMER PRICE INDEX Laspeyres Index – Base year quantity as the weight σ 𝑃𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑄𝑏𝑎𝑠𝑒 𝐶𝑃𝐼𝑡 = ∗ 100 σ 𝑃𝑏𝑎𝑠𝑒 𝑄𝑏𝑎𝑠𝑒 Paasche’s Index – Current year quantity as the weight σ 𝑃𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑄𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝐶𝑃𝐼𝑡 = 𝑥 100 σ 𝑃𝑏𝑎𝑠𝑒 𝑄𝑐𝑢𝑟𝑟𝑒𝑛𝑡 5  CPI IN INDIA Price data are collected from selected 1114 urban Markets and 1181 villages covering all States/UTs through personal visits by field staff of Field Operations Division of NSO, MoSPI on a weekly roster. 7  PRICE INDEX Producer Price Index (PPI) : Measures the cost of a fixed basket of goods and services σ 𝑃𝑡 𝑃𝑃𝐼𝑡 = 𝑥 100 σ 𝑃0 Weighted index for either when the goods leave the place of production or as they enter the production process Comprises of mostly raw materials and intermediate goods 8  CORE INFLATION Core inflation: Change in the costs of goods and services excluding those from the food and energy sectors. Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly. Core inflation is important because it's used to determine the impact of rising prices on consumer income. 9  COSTS OF INFLATION Costs of extremely high inflation are easy to see – If prices rise rapidly enough, money stops being a useful medium of exchange Costs of low, expected inflation are difficult to see – Regardless, public has a distaste for it → becomes a policy issue Two qualifications: – The costs of holding currency rise along with the rate of inflation, and the demand for currency decreases → Shoe Leather Costs – Producers or suppliers wait and watch before raising their prices → Menu costs of inflation  COSTS OF INFLATION Case (a): Perfectly anticipated inflation Suppose an economy has been experiencing inflation of 5% and the anticipated rate of inflation is also 5%, then all contracts will build in the expected 5% inflation – Nominal interest rates account for the inflation – Long term labor contracts account for the inflation – Tax brackets are typically adjusted to account for the inflation Inflation has no real costs,  COSTS OF INFLATION Case (b): Imperfectly anticipated inflation Most contracts are written in nominal terms – When actual inflation is higher than expected inflation (𝜋𝐴 > 𝜋𝐸 ), creditors (depositors) receiver lesser returns – When actual inflation is lower than expected inflation (𝜋𝐴 < 𝜋𝐸 ), creditors (depositors) receiver more returns The possibility of unexpected inflation introduces an element of risk, which might prevent some from making some exchanges they otherwise would undertake Unexpected inflation has distributional cost (redistributes wealth and income between debtors vs. creditors)  INFLATION AND OUTPUT Prices are related with output in the following manner – 𝑃𝑡+1 = 𝑃𝑡 [1 + λ 𝑌 ∗ − 𝑌 ] Where 𝑃𝑡+1 = Price levels in the next period 𝑃𝑡 = Price levels in the current period Y* = Potential Output Y = Current equilibrium output of the economy  INFLATION AND OUTPUT Inflation is related with output in the following manner – 𝝅𝒕 = 𝝅𝑬 + 𝝀(𝒀𝟎 − 𝒀∗ ) CASE I: Recessionary Gap 𝑌0 < 𝑌 ∗ Unemployment exists as resources are underutilized Workers are willing to work for less wages as they want jobs → wages negotiation takes place Downward pressure on wages, w and prices, P CASE II: Inflationary Gap 𝑌0 > 𝑌 ∗ Overemployment exists as resources are overutilized Shortage of labour → Workers have to be paid more wages for overtime → wages negotiation takes place Upward pressure on wages, w and prices, P  INFLATION AND OUTPUT Thus Inflation is related with unemployment in the following manner – 𝝅𝒕 = 𝝅𝑬 + 𝝐(𝒖∗ − 𝒖) Where 𝑢∗ = Natural rate of unemployment u = unemployment in the current period This (inverse) relationship between inflation and unemployment is known as Phillip’s Curve (PC)  THE PHILLIPS CURVE Prices tend to adjust slowly → AD drives the economy in the meantime The speed of price adjustment is illustrated by the Phillips curve, which plots the inflation rate against the unemployment rate In the short run, AS curve is relatively flat, and movements in AD drive changes in prices, output, and unemployment  THE PHILLIPS CURVE In 1958 A.W. Phillips published a study of wage behavior in the U.K. between 1861 and 1957 The main findings are: → There is an inverse relationship between the rate of unemployment and the rate of increase in money wages → From a policymaker’s perspective, there is a tradeoff between wage inflation and unemployment  THE POLICY TRADEOFF PC quickly became a cornerstone of macroeconomic policy analysis since it suggests that policy makers could choose different combinations of u and π rates From a policymaker’s perspective, there is a tradeoff between wage inflation and unemployment Can choose low u if willing to accept high  Can maintain low  by having high u In reality the tradeoff between unemployment and inflation is a medium run phenomenon Tradeoff disappears as AS becomes vertical Source: Google photos 20