Question

Eurozone unemployment rose to 10.7 percent. At the same time, eurozone inflation unexpectedly rose to 2.7 percent a year, up from the previous month's 2.6 percent a year. a. How does the Phillips curve model account for a very high unemployment rate? b. Explain the change in unemployment and inflation in the eurozone in terms of what is happening to the short-run and long-run Phillips curves.

Short answer

High unemployment with rising inflation may involve supply shocks or changes in expectations. The short-run Phillips curve shifts; in the long run, it returns to the natural unemployment rate.

Step-by-step solution

Understand the Phillips Curve

The Phillips curve represents the inverse relationship between the rate of inflation and the rate of unemployment. It suggests that with higher inflation, unemployment tends to be lower, and vice versa.

Analyze the Current Situation

Given that the eurozone unemployment is at 10.7% and inflation has risen to 2.7%, this suggests a scenario of high unemployment coupled with rising inflation.

Interpreting High Unemployment Rate

(a) According to the Phillips curve, a very high unemployment rate typically corresponds to lower inflation. However, other factors like supply shocks or changes in expectations can also affect inflation even when unemployment is high.

Short-Run Phillips Curve

(b) In the short run, the Phillips curve may shift due to external factors, such as supply shocks, which can cause inflation to rise even when unemployment is high. This can be represented as a leftward shift of the short-run Phillips curve (SRPC).

Long-Run Phillips Curve

In the long run, the Phillips curve is vertical at the natural rate of unemployment. Structural changes in the economy, policy shifts, or changes in inflation expectations can cause the short-run Phillips curve to shift without changing the long-term relationship.

Conclusion

The changes in unemployment and inflation in the eurozone suggest that there might be external factors affecting the short-run Phillips curve. Over time, the long-run Phillips curve indicates that the economy will revert to the natural rate of unemployment regardless of inflation.

Key concepts

headline of the respective core concept

The unemployment rate represents the percentage of the labor force that is currently without work but actively seeking employment. It's a critical indicator of economic health. A high unemployment rate means that a significant portion of the workforce wants to work but cannot find jobs.

Unemployment can have various causes, including:

• Economic downturns
• Changes in industry demands
• Technological advancements

In the context of the Phillips curve, changes in the unemployment rate can affect inflation.

headline of the respective core concept

Inflation is the rate at which the general level of prices for goods and services rises, and subsequently, purchasing power falls. Central banks attempt to limit inflation, and avoid deflation, to keep the economy running smoothly.

Factors that can lead to inflation include:

• Demand-pull inflation, where demand for goods and services exceeds supply
• Cost-push inflation, where the costs of production increase
• Monetary inflation, where the money supply grows too quickly

Understanding inflation is crucial for interpreting the movements along the Phillips curve.

headline of the respective core concept

The short-run Phillips curve (SRPC) illustrates the inverse relationship between inflation and unemployment, implying that lowering unemployment can lead to higher inflation and vice versa.

In the short run, this relationship can be affected by external factors and shocks. For example, an unexpected increase in oil prices (supply shock) can lead to both higher inflation and unemployment, shifting the SRPC leftward.

Factors influencing the SRPC include:

• Expectations of future inflation
• Supply shocks
• Government policies

In the eurozone scenario, high unemployment and rising inflation indicate a potential shift in the SRPC.

headline of the respective core concept

The long-run Phillips curve (LRPC) differs from the SRPC as it is vertical at the natural rate of unemployment. In the long run, there is no trade-off between inflation and unemployment because inflation expectations adjust.

The natural rate of unemployment is determined by structural factors in the labor market, such as:

• Frictional unemployment
• Structural unemployment
• Labor market policies and institutions

Over time, economies tend to revert to this natural rate regardless of inflation, as adjustments in expectations occur. Structural changes and economic policies can shift the LRPC.

headline of the respective core concept

The natural rate of unemployment is the level at which the labor market is in equilibrium, and all unemployment is frictional and structural, not cyclical. This means that even in a healthy economy, some level of unemployment will exist due to job searching, skills mismatches, and other factors.

Key influences include:

• Labor market efficiency
• Education and training systems
• Technological changes

Understanding the natural rate of unemployment helps in interpreting the long-term behavior of the Phillips curve and the overall economy. It marks the point towards which the economy moves in the long run, regardless of short-run fluctuations in inflation.