Inflation, Unemployment, and the Phillips Curve

This chapter discusses inflation and unemployment, as well as problems of stabilization. There is a trade-off between inflation and unemployment. Professor Larraín explains setting the expected level of aggregate demand as per future inflation levels. Using graphs and equations, he talks about Okun's Law, which relates unemployment to the output gap, and also explains the Phillips curve. There was a negative relationship between unemployment and inflation until the 1970s oil shocks. In the long-term, moving inflation alone will not be able to reduce the unemployment level; there is a positive trade-off, but only in the short-term. Larraín also discusses three types of the Expectation Formation Mechanism: static, adaptive, and rational.

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