1. Is there a tradeoff between inflation and the unemployment rate?

The Phillips curve is a graph showing the relationship between the inflation rate and the rate of unemployment. In the short run, the Phillips curve has a downward slope, indicating a possible tradeoff between inflation and unemployment. In the long run the Phillips curve is vertical, indicating that no such tradeoff is possible.

2. How does the tradeoff between inflation and the unemployment rate vary from the short to the long run?

The short-run downward slope of the Phillips curve is caused by shifts in aggregate demand while aggregate supply stays constant. In the long run no tradeoffs are possible because adaptations are made and the aggregate supply curve shifts.

3. What is the relationship between unexpected inflation and the unemployment rate?

Unexpected inflation can decrease unemployment in three ways. If workers have constant reservation wages and constant expectations about inflation, an unexpected increase in inflation raises nominal wages without raising real wages. Workers do not realize that inflation has increased, so they accept smaller real wages and unemployment decreases.

When aggregate demand is greater than expected, inventories fall and prices on remaining goods in stock are higher. Businesses hire new workers to increase production to offset the falling inventories.

If wage contracts exist, employers must adjust employment to changing conditions. If revenues fall, employers must reduce costs, either by lowering wages or by getting rid of workers. If a wage contract precludes lowering wages, a decrease in inflation will result in unemployment.

4. How are macroeconomic expectations formed?

Adaptive expectations are expectations based on past experience. People expect things to be as they were before, and they take nothing else into account. Rational expectations are formed using all available information, including, but not limited to, past events.

5. What makes government policies credible?

A government’s policies are credible only if they are not time inconsistent. People will refuse to believe the announcements of a government that changes its policies when conditions change. The central bank of a country can achieve credibility by fixing the growth rate of the money supply by law or by creating incentives for policymakers to follow through on announced plans.

6. Are business cycles related to political elections?

Some economists believe in the existence of a political business cycle, in which the incumbent administration stimulates the economy just before the election. After the election, unemployment and inflation rise. There is no conclusive evidence of political business cycles in the United States.

7. How do real shocks to the economy affect business cycles?

The economy can expand or contract as a result of changes in the real economic variables, such as the weather, technology, and so forth. These real shocks are to be distinguished from discretionary fiscal and monetary policies.

8. How is inflationary monetary policy related to government fiscal policy?

The government must finance its spending through taxes, borrowing, or changes in the money supply. If the government cannot or will not borrow and deficits continue, monetary policy must be inflationary.