ECONOMIC DEVELOPMENT - In this image, an economy can either experience 3%

Short-run trade-off between Inflation and Unemployment unemployment at the cost of 6% of inflation, or increase
unemployment to 5% to bring down the inflation levels
Phillips Curve to 2%.
- Economic concept developed by economist, A. W.
Phillips stating that INFLATION AND - An increase in AD has caused the economy to shift from
UNEMPLOYMENT HAVE A STABLE AND point A to point B. Unemployment has fallen, but a
INVERSE RELATIONSHIP. trade-off of higher inflation.

- The Theory claims that with economic growth comes - If an economy experienced inflation, then
inflation, which in turn should lead to more jobs and less the Central Bank could raise interest rates.
unemployment.
- Higher interest rates will reduce consumer
- Proposed in 1958. Phillips tracked wage changes and spending and investment leading to lower
unemployment in Great Britain from 1861 to 1957, and aggregate demand. This fall in aggregate demand will
found that there was a stable, inverse relationship lead to lower inflation.
between wages and unemployment.
- However, if there is a decline in Real GDP,
- However, it was disproven empirically due to occurrence firms will employ fewer workers leading to a
of STAGFLATION in the 1970s, because there were rise in unemployment.
high levels of both inflation and unemployment.
Economic Output
- Inverse relationship between Inflation and - In economics, output is the quantity of
Unemployment: goods and services produced in a given
time period. The level of output is
- UNEMPLOYMENT = INFLATION determined by both the aggregate supply
and aggregate demand within an economy.
The relationship however, is not linear, Phillips curve traces National output is what makes a country
and L-shape when the unemployment rates on the X-AXIS rich, not large amounts of money.
and the inflation rate on the Y-AXIS.
- Anything that causes labor, capital, or
Why is there a trade-off between Unemployment and efficiency to go up or down results in
Inflation? fluctuations in economic output.

- Changes in aggregate demand translate as movements Fluctuations in Output

along the Phillips curve. For instance, if the economy
experiences a rise in AD, it will cause increased output. • short run = output fluctuates with shifts in
- As the economy comes closer to full employment, we either aggregate supply or aggregate
also experience a rise in inflation. demand;
- However, with the increase in real GDP, firms take on
more workers leading to a decline in unemployment •Long run = only aggregate supply affects
(a fall in demand deficient unemployment) output.
- Thus, with faster economic growth in the short-term, we
experience higher inflation and lower unemployment.
 - Real and Nominal Variables: classical economists
stated that real and nominal variables can be analyzed
separately.

Keynesian Theory

- Keynesian economics states that in the short-run,

especially during recessions, economic output is
substantially influenced by aggregate demand (the
total spending in the economy).

- According to the Keynesian theory, aggregate demand

does not necessarily equal the productive capacity of
CLASSICAL THEORY the economy.

- Classical economics focuses on the growth in the - Keynesian theorists believe that aggregate demand is
wealth of nations and promotes policies that create influenced by a series of factors and responds
national expansion. During this time period, theorists unexpectedly. The shift in aggregate demand impacts
developed the theory of value or price which allowed production, employment, and inflation in the economy.
for further analysis of markets and wealth. It analyzed
and explained the price of goods and services in Characteristic Beliefs:
addition to the exchange value.
- Unemployment is the result of structural inadequacies
Classical Theory Assumptions within the economic system. It is not a product of
laziness as believed previously.
- Self-regulating markets: classical theorists believed
that free markets regulate themselves when they are - During a recession, the economy may not return
free of any intervention. Adam Smith referred to the naturally to full employment.
market's ability to self-regulate as the
"INVISIBLE HAND" because markets move - An active stabilization policy is needed to reduce the
towards their natural equilibrium without outside amplitude of the business cycle. Keynesian economists
intervention. believed that aggregate demand for goods and services
not meeting the supply was one of the most serious
- Flexible prices: classical economics assumes that economic problems.
prices are flexible for goods and wages. They also
assumed that money Only affects price and wage - Excessive saving, saving beyond investment, is a
levels. serious problem that encouraged recession and even
depression.
- Supply creates its own demand: based on Say's
Law, classical theorists believed that supply creates its - Cutting wages will not cure a recession.
own demand. Production will generate an income
enough to purchase all of the output produced. - Overcoming an economic depression requires
Classical economics assumes that there will be a net economic stimulus, which could be achieved by cutting
saving or spending of cash or financial instruments. interest rates and increasing the level of government
investment.
- Equality of savings and investment: classical
theory assumes that flexible interest rates. Will CAUSES OF UNEMPLOYMENT:
always maintain equilibrium. 1. Large number of technological advances,
2. Jobs have become increasingly specialized
- Calculating real GDP: classical theorists 3. Companies prefer hiring a few people on board.
determined that the real GDP can be calculated 4. People voluntarily choose to remain unemployed.
without knowing the money supply or inflation 5. A higher literacy rate among men and women.
rate. 6. The issue of the immobility of the workforce
 EFFECTS OR CONSEQUENCES OF
UNEMPLOYMENT:
1. Affects the economy of a region very negatively.
2. Reduces the spending power of both the employed as
well as unemployed.
3. Makes the individual feel very depressed.
4. It is a cause of distress to the entire family.
5. Increase in crime in the country.

CAUSES OF INFLATION:
1. The Money Supply Inflation is primarily caused by
an increase in the money supply that outpaces
economic growth WEALTH EFFECT
2. The National Debt.
- The wealth effect holds that as the price level
3. Demand-Pull Effect. increases, the buying power of savings that
4. Cost-Push Effect. people have stored up in bank accounts and
5. Exchange Rate Inflation. other assets will diminish, eaten away to some
extent by inflation.
RISKS OF PERSISTENTLY HIGH INFLATION:
1. Income redistribution. INTEREST RATE EFFECT
2. Falling real incomes. - The interest rate effect explains that as outputs
3. Negative real interest rates. rise, the same purchases will take more money
4. Cost of borrowing. or credit to accomplish.
5. Risks of wage inflation.
6. Business competitiveness. THE AGGREGATE SUPPLY CURVE
7. Business uncertainty.
- The horizontal axis of the diagram shows real GDP
that is, the level of GDP adjusted for inflation. The
THE AGGREGATE DEMAND CURVE vertical axis shows the price level.
- Aggregate demand refers to the amount of total
- The price level shown on the vertical axis
spending on domestic goods and services in an
represents prices for final goods or outputs
economy. It is what economists call total planned
bought in the economy, not the price level for
expenditure. intermediate goods and services that are inputs to
production.
Four Components of Demand:
- Consumption - Aggregate supply is the total amount of goods and
services that firms are willing to sell at a given
- Investment
price in an economy.
- Government spending
- Net exports - exports minus imports - In a standard AS-AD model, the output is the x-
axis and price (p) is the y-axis. Aggregate supply
One of the factors that determine AD is the price level and aggregate demand are graphed together to
determine equilibrium. The equilibrium is the
C = consumption spending;
point where supply and demand meet to
I = investment spending; determine the output of a good or service.
G = government Spending;
X = spending on exports;
M = imports

Aggregate Demand = C + I + G + (X - M)
 - The aggregate supply curve describes how
suppliers will react to a higher price level for final
outputs of goods and services while the prices of
inputs like labor and energy remain constant.

Why does aggregate demand cross potential GDP line?

- The economic intuition here is that if prices for

outputs were high enough, producers would
make fanatical efforts to produce: all workers
would be on double-overtime, all machines would
run 24 hours a day, seven days a week. Such hyper-
intense production would go beyond using
potential labor and physical capital resources fully
to using them in a way that is not sustainable in
the long term. Thus, it is indeed possible for
production to sprint above potential GDP, but
only in the short run.

- In the short run, it is possible for producers to

supply less or more GDP than potential if demand
is too low or too high.

- In the long run, however, producers are limited to

producing at potential GDP.

- For this reason, economists also refer to the AS

curve as the short run aggregate supply curve, or
SRAS curve.