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Macroeconomics


 
 

The Relationship Between Inflation and Unemployment

 

Quantity Theory of Inflation

  1. Inflation can be explained by the equation MV = PQ, where M is the money supply, V is the velocity of money (nominal GDP/money supply), P is the price level, and Q is the quantity of real goods sold. PQ is also equal to the nominal GDP.

  2. The theory assumes V is constant in the long run. Therefore, nominal GDP growth (PQ) is directly related to money supply growth in the long run.

  3. The theory also assumes that the real output Q is independent of the money supply and is determined by factors outside of the equation.

  4. The conclusion then is that in the long-term changes in the money supply directly cause changes in the price level (inflation).

 
 

Inflation and Unemployment

  1. We can see the general relationship between inflation and unemployment in the AS/AD model. If the short-run equilibrium is at a point to the right of potential output, then the unemployment rate will be low and there will be inflationary pressures at work in the economy.

  2. The Phillips curve expresses the relationship between inflation and unemployment.

    1. The short-run Phillips shows the trade-off between inflation and unemployment given a fixed expectation about the future inflation rate.

    2. The long-run Phillips curve is a vertical line at the target rate of unemployment, showing that full output occurs in the long run at the target unemployment rate regardless of the annual inflation rate.