1. The Phillips Curve
The Phillips curve shows the inverse relationship between inflation and unemployment.

1. The inflation-unemployment tradeoff is a short-run phenomenon.
   
   
2. Short-run versus long-run tradeoffs
   
   

• In the short run, when aggregate demand increases and thereby pushes output above the natural rate, unemployment falls and inflation increases. This moves the economy up along the short-run Phillips curve.
  
  
• In the long run, when price expectations adjust upward, the aggregate supply curve shifts to the left. This shifts the Phillips curve to the right.
  
  

2. The Role of Expectations
Teaching Strategy: Be sure to work through the long- and short-run Phillips curves carefully. This material tends to be difficult for students.

1. Expected versus unexpected inflation
   
   

• Wage expectations and unemployment: When wage offers are unexpectedly high, workers shorten their job searches; hence, the unemployment rate falls.
  
  
• Inventory fluctuations and unemployment: When aggregate demand is greater than expected, inventories fall below desired levels, producers increase output to restore inventory levels, and unemployment falls.
  
  
• Wage contracts and unemployment: Contracts create nominal wage stickiness, which establishes a short-run tradeoff between inflation and unemployment.
  
  

3. Forming expectations

• Adaptive expectations are formed by people using past information about a variable.
  
  
• Rational expectations are formed by people using all available information efficiently. In its simplest form, the rational expectations hypothesis states that people learn from their mistakes, making no systematic forecasting errors.
  
  

3. Sources of Business Cycles

1. The political business cycle is generated by politicians exploiting the short-run tradeoff between inflation and unemployment.
   
   
2. Real business cycles may be accounted for by real shocks to aggregate supply.
   
   Teaching Strategy: Point out that a randomly generated series of numbers can appear to be a trend and a business cycle. So, even though data such as GDP may appear to follow a cycle, it might be generated by a series of random shocks.
   
   

4. The Link Between Monetary and Fiscal Policies
The government budget constraint indicates that government spending can be financed only through taxes, borrowing, or money creation. In many developing countries, money creation has been the only avenue for financing persistent deficits

Teaching Strategy: Point out that monetary and fiscal policies are interdependent.


5. Economic Growth

1. The determinants of growth
   
   Teaching Strategy: Point out that when resources increase or technology improves, the long-run aggregate supply curve shifts to the right. At every price level, costs are lower and profits are greater; thus, firms will increase production.
   
   

• Labor: An increase in the labor force will shift the long-run aggregate supply curve to the right.
  
  
• Capital: Capital is a critical resource, especially in developing economies, and is directly related to ability to save.
  
  
• Land: The experience of Japan shows that land is not a necessary resource for growth, but, nonetheless, it is important.
  
  
• Technology: Technological improvements increase the efficiency of a given capital stock and labor force.
  
  

6. Productivity

Total factor productivity is the ratio of an economys output to its capital and labor.

Teaching Strategy: Reflect with your students on some of the technological improvements that have radically increased productivity. Some examples are pesticides and fertilizers used in food production, robotics in automobile production and other industries, and computers in the office.

Productivity and economic growth: Growth in output is the sum of the growth of total factor productivity and the growth in resources. Productivity growth accounts for the difference in growth rates among countries.

Teaching Strategy: Point out that a slowdown in productivity can occur without being immediately apparent. This is because the causes of a productivity slowdown occur gradually and slowly. For example, you can have a discussion of the U.S. productivity changes.