that there is no money illusion i.e. people and firm care only about
real variables.
The following diagram shows the vertical
long run Phillips curve
Vertical Long Run Phillips Curve
0
2
4
6
8
10
12
14
1
2
3
4
5
6
Unemployment Rate (%)
In
te
re
st
R
at
e
(%)
FIGURE 9.9: A VERTICAL LONG RUN PHILLIPS CURVE
Whatever the long run rate of money growth and inflation,
eventually economy get back to natural rate of unemployment rate
U* which is unaffected by inflation.
Thus if money supply increases at 6
percent forever,
eventually the economy would reach the long run equilibrium at
point E (U = U*).
Hence in long run, there is no trade-off between
inflation and unemployment.
The short run Phillips curve is given as PC
1
. In the short run
a boost to aggregate demand will take economy to point ‗A‘.
Thereafter the rise in prices and wages
would push down the real
money supply and the aggregate demand to the point ‗E‘ along the
short run Phillips curve PC
1
.
Conversely any drop in aggregate
demand would initially
take the economy to point such as ‗B‘. Higher unemployment will
then moderate the growth
of wage and price will rise, real money
A
B
*
U
E
1
PC
supply reduce the interest rate and
raise aggregate demand and
the economy move back to point ‗E‘.
To conclude the short run Phillips curve describe the
temporary trade-off between inflation
and unemployment in
economy is adjusting to a change in aggregate demand. The height
of short run Phillips curve is determined by the rate of money
growth and inflation in the long run.
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