• <b>United States Federal Reserve</b>

Intermediate Macroeconomics


11. Monetary Policy and the Phillips Curve


Here we introduce the Phillips curve and the Taylor rule, which together form an alternative framework to examine the short-run trade-off between unemployment and inflation and the role for monetary policy. The Phillips rule describes the relationship between inflation and unemployment. We derive a Phillips rule for the short-run and long-run, and consider a modern innovation called the New Keynesian Phillips curve which considers the role inflation expectations has on this trade-off. The Taylor rule is prescription for monetary policy in which the central bank influences the interest rate in response to targets for inflation and unemployment.


[Download PDF]

Short-Run Phillips Curve

The Phillips curve is an illustration of the short-run trade-off between inflation and unemployment. We use the aggregate supply and aggregate demand model to derive this relationship. This relationship is useful because it demonstrates how monetary policy can work to improve the unemployment situation. We have demonstrated in past Pencasts that increasing the money supply causes an increase in inflation. The Phillips curve suggests that an increase in inflation can lead to a decrease in unemployment. [Play Pencast]


[Download PDF]

Long-Run Phillips Curve

The trade-off between inflation and unemployment shown in the previous Pencast is only a short-run trade-off. We show in this Pencasts that an increase in inflation has no impact on unemployment. This suggests that using monetary policy to target real macroeconomic outcomes such as employment should only serve as a short-run strategy. [Play Pencast]


[Download PDF]

New Keynesian Phillips Curve

The New Keynesian Phillips curve illustrates how the short-run trade-off between inflation and unemployment depends also on inflation expectations. An increase in inflation expectations causes an upward shift in the Phillips curve, leading to higher inflation even when the unemployment rate is unchanged. This has important consequences for monetary policy. While an increase in money supply causing an increase in inflation may have a beneficial trade-off for unemployment, the effect will be muted if the policy causes economic agents to revise upward their inflation expectations. [Play Pencast]


[Download PDF]

Taylor Rule

The Taylor rule is prescription for monetary policy in which the central bank influences the interest rate in response to targets for inflation and unemployment. This framework is more inline with the conduct of modern monetary policy than the money supply / money demand models used previous sections. Since the early 1980s, the United States has explicitly influenced the interest rate in order to achieve target levels for inflation, employment, and real GDP. In this Pencast we describe an equation that models this behavior. [Play Pencast]


Return to Intermediate Macroeconomics Home