Monday, February 1, 2010

Phillips Curve

Summary: Two-minute drill

Say inflation this period is 6%, people expect inflation to be 2% and the natural rate of unemployment is 5%. Using The inflation augmented Phillips Curve equation, find the value of unemployment. Assume that Pt = Pe - 2(U - Un).

The unemployment rate would have to be 3%. This equation leads to some deep insights into the working of the economy. Unemployment would have to be 2% less than the natural rate to push inflation to 6%. Workers would have to work longer and harder. Now suppose Okun's Law holds and every 1% decrease in the unemployment rate leads to a 2% increase in GDP. That means that GDP is growing at 4%--just ahead of it's natural rate.

Now suppose that the unemployment rate is 10% and the natural rate is 5%. Would you agree that it might be as long as 5 years before the unemployment rate equals the natural rate? I don't forecast any better than a divining rod, but if the economy chugs along at 2% annual growth, it might be 2015 before the recession ends. It's interesting to me that the FRED graph shown, shows that the recession is over with GDP around 1.5%.

About the Author: Mike Fladlien is an AP Economics teacher from Muscatine High School in Muscatine, IA. He is an author.


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