Reference no: EM131733012

The theory of the short run "Phillips Curve"--that is, the tradeoff between inflation and unemployment--is widely understood. I call it the "newspaper model of the economy," because this is the standard theory presented in news articles whenever short run fluctuations of the economy are discussed. Most people have heard it somewhere in their exposure to current macroeconomic events.

Here it is: if the economy is booming, people are working more hours earning higher incomes, are spending those incomes, and so businesses are producing more and more goods and services, and consequently businesses start hiring, unemployment falls, and businesses start raising prices, workers ask for higher wages, all prices and wages start to rise, and so inflation rises.

If the economy is sluggish or contracting, people are working less hours earning lower incomes, and spending less of their lower incomes, and so business are producing less and less goods and services, and consequently business start laying off workers, unemployment rises, and business start lowering prices, forcing wage freezes or reductions on remaining workers, all prices and wages stop rising, maybe even fall, and so inflation falls.

Hence an inverse relationship between unemployment and inflation.

This story captures how we think things work.

What exceptions or complications are there to this story?

Does the macroeconomic world really behave this way?