EXEE 2104

Macroeconomics llB
Tutorial 5: Output, Inflation, and Unemployment:
Alternative Views

Group 2E:
FATIMAH BINTI ALI EEE 070049
LIM WEI ZING EEE 070084

1
 Question 1

Milton Friedman believes that there will be

only a temporary trade-off between
inflation and unemployment. Explain why.

2
 The Short Run Phillips Curve
• The Phillips
Curve shows a
relationship
between Inflation
unemployment Rate PC
rate and
inflation rate. 6 B
• The short run
Phillips Curve
has a negative
slope.
• The negative
slope show that 2 A
the
unemployment
rate and the
2 4 Unemploymen
inflation rate
are inversely Rate
related.
( there is a
trade off
3 between the
two)
 The Long Run Phillips Curve

• Inflation Inflation LRPC

and Rate
unemployme High
nt are B
Inflatio
unrelated in n
the long run.
• The LR Low
A
Phillips Inflatio
Curve is n
vertical at
the natural Natural Rate Unemployme
rate of of nt Rate
unemployme Unemploym
nt. ent

4
 • Milton Friedman said there is always a
temporary trade-off between inflation and
unemployment; there is no permanent trade-
off.
• In other words, if policymakers were to try to
keep unemployment low through a policy of
generating higher inflation, they would
achieve only temporary success.
• According to Friedman, unemployment would
eventually rise again, even as inflation
remained high. The economy would suffer
"stagflation."

5
 • Friedman applied the idea of rational
behaviour. He argued that after a sustained
period of inflation, people would build
expectations of future inflation into their
decisions, nullifying any positive effects of
inflation on employment.
• For example, one reason inflation may lead to
higher employment is that hiring more
workers becomes profitable when prices rise
faster than wages. But once workers
understand that the purchasing power of their
wages will be eroded by inflation, they will
demand higher wage settlements in advance,
so that wages keep up with prices.
• As a result, after inflation has gone on for a
6
while, it will no longer deliver the original
boost to employment. In fact, there will be a
 Short-Run and Long-Run Phillips
Curves
As labor
PC(Pe=P)
suppliers Inflation PC(Pe=0)
PC(Pe=2%)

come to
anticipate the 6
higher
inflation rate,
the short-run 4
Phillips curve
shifts from B
2 C
PC(Pe=0) to
PC (Pe=2%).
The A
Unemployment
unemploymen 2 4 6
t rate returns
to the natural
rate of 6%: the
inflation rate
7 remains
higher at 2%
 Question 2

Suppose that there is a permanent increase

in the level of government spending
financed by a larger budget deficit. What
would Keynesians predict would happen to
inflation and unemployment as a result?
What would Monetarists predict would
happen to inflation and unemployment as a
result?

8
  When the expenditures of a government are
greater than its tax revenues, it creates a
deficit in the government budget; such a deficit
is known as deficit spending. This therefore
causes the government to borrow capital from
the 'world market', increasing further debt,
debt service (interest) and interest rates.
 When the economy has high unemployment,
an increase in government purchases creates a
market for business output, creating income
and encouraging increases in consumer
spending, which creates further increases in
the demand for business output. This raises the
real gross domestic product (GDP) and the
9 employment of labour, and lowers the
unemployment rate.
 Effect of an increase in Government
Spending
• G AD curve The Keynesian View
shift up to the right r
( from AD0 to AD1 )
P ( from P0 to P1 ) AS
and Y (from Y0 to
Y1 ) P1
•P cause
P0
inflation.

AD1(G1)
AD0(G0
) Y
Y0 Y1

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 • In the Short
Phillips Curves
Run, there is a
trade off
between
inflation and
unemployment
rate.
•High rate
growth of output
correspond to
low
unemployment
and high rates of
inflation.
• As suppliers of
labor anticipate
that prices are
rising, PC will
shift to the right.
• If the money
growth is
continued at 5%,
the economy will
return to the
11 natural 6% rate
of
 THE MONETARIST APPROACH
Monetarists argue:
a) attempt to reduce unemployment by
increasing the government deficit do not
succeed if the government finances the
additional deficit by borrowing other than
from banks. The additional supply of bonds
increases interest rates, and this reduces
private investment, with reduction in
employment and output, creating
inflationary pressures.
b) national income increases if the
additional government deficit is financed by
increases in cash creation or borrowing
12 from banks. This monetary policy increases
  The monetarist conclusion is that Keynesian
fiscal policies CAN DO NOTHING TO AFFECT
THE LONG-TERM LEVEL OF UNEMPLOYMENT
and that government policies affect the
inflation rate only if the supply of money is
changed.

13
 Question 3
What is meant by the natural rate of
unemployment? According to the
Monetarist view, does an expansionary
monetary policy lower the natural rate of
unemployment temporarily or
permanently?

14
 What is meant by the natural
rate of unemployment?
The natural rate of unemployment is
defined by the Friedman as the rate “which
has the property that that it is consistent
with equilibrium in corresponding natural
rate of employment, will be such that labor
demand equals labor supply at an
equilibrium real wage.

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 a. Natural
Rate of
Employment
W/P

Ns(W
 The labor demand Nd

(W/P)
Pe=p schedule in figure a of
*
the figure is the
familiar marginal
MPN
product of labor
N* N schedule (MPN).
b. Natural  At N*, the natural rate
Rate of
Y Output of employment, Nd =
Ns
Y F(K,N)  Figure b by using
*
production function ,
we can find the level of
output that will result
N
16
N* from an employment
 According to the Monetarist views, does an
expansionary monetary policy lower the
natural rate of unemployment temporarily or
permanently?
 Expansionary monetary policies, for example,
move output above the natural rate and move
the unemployment rate below the natural rate
for a time.
 The increased demand resulting from such, an
expansionary policy would also cause prices to
rise.
 In the short-run, the price adjustment would
not be complete, as in the classical theory
where increases in demand cause prices to rise
but do not affect output.
 Monetarists believe that expansionary
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monetary policy can only temporarily move the
unemployment rate below the natural rate
 PC(Pe=
p) Temporarily, expansionary monetary policy
P PC(Pe=4% lower the unemployment rate at B (SR).
)

Permanently, the unemployment rate remain

unchanged at C (LR).

D E
4%

B
2% C
PC(Pe=4
%)

U
6%
PC(Pe=
0)
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 Question 4
Why is the Philips curve implied by the
Keynesian model downward sloping?
Does this apply to both the long- run
and the short-run effects of the
monetary policy? Is there any
difference between monetarists and
Keynesian views on the Philips curve?

19
 Why is the Philips curve implied by
the Keynesian model downward
sloping?
P(Inflatio
n Rate)
 The Philips curve show a
PC relation between the
unemployment rate (U)
and inflation (p).
 In the short-run Philips
curve has negative slope.
P0  It means that the
downward sloping is that
the unemployment rate
and the inflation rate are
P1 inversely related.
 Have trade off
unemployment in short-
U0 U1
run.
 When u p that why
the Philips curve
U(Unemployment
Rate)
downward sloping.
 But it only imply in short-
20 run
 Phillips curve viewed by Keynesian is downward sloping because:
- There is a –(ve) relationship between inflation and unemployment.
- High inflation rate, low unemployment rate and vice versa. But it only imply
in
short run.

In short-run, increase in inflation will

decrease unemployment. While decrease
╥ in inflation will increase unemployment.
This is because the expected price level
(Pe) is depending on past price.

╥0

╥1

U
U0 U1

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 Does this apply to both the long- run and the
short-run effects of the monetary policy?
Inflation  No , however the
rate
downward sloping curves
does not occur in the
High long run.
Inflation
 In the long-run the
Phillips curve is vertical
at the natural rate of
unemployment.
 In the long run increase
Low in inflation,
inflation
unemployment remain
Natural rate of unchanged
Unemployment
 Friedman and Phelps
unemployment
Rate says that inflation and
unemployment are
22 unrelated in the LR.
 Is there any difference between
monetarists and Keynesian views on the
Philips curve?
 According to keynesian in the SR there is trade
off between inflation and unemployment,
where decreasing in unemployment will
increase inflation and vice versa.
 When the PCSR downward sloping the same
things will happened in the monetarist theory.
 That means there is no diffirent PC viewed by
Monetarist and Keynesians. 

23
 Question 5
Contrast monetarist and classical views on
the short-run effects of an increase in the
quantity of money.

24
 Classical View
• In classical
model, an P AS
increase in
money supply
does not affect
the output P1 B
because the
AS curve is
P0 A
vertical. AD1
• Ms increase,
AD0
AD shifts to
the right, P Y
increase.. Y0

25
 Monetarists View
• In monetarist
model, an
increase in P AS
money supply
will affect the
output
because the P1
AS curve is P0
upward AD(M1)
sloping. AD(M0)
• Ms increase,
AD shift to Y
right. P Y0 Y1
increase and Y
increase.

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