PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand...

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PHILLIPS CURVE

Transcript of PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand...

Page 1: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

PHILLIPS CURVE

Page 2: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Phillips CurveShort and Long Run Phillips Curves

• William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published in the quarterly journal Economica.

• In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined

Page 3: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

PHILLIPS CURVESHORT AND LONG RUN PHILLIPS

CURVES• In the years following Phillips' 1958 paper, many economists in

the advanced industrial countries believed that his results showed that there was a permanently stable relationship between inflation and unemployment.

• One implication of this for government policy was that governments could control unemployment and inflation with a Keynesian policy.

• They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment.

• For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

Page 4: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

LRAS

“A”

When the Economy is at Full Employment (“F-E RGDP”) Aggregate Demand (AD), Short Run Aggregate Supply (SRAS)and Long Run Aggregate Supply (LRAS) all intersect at the same point “A”

1. Actual RGDP = Potential RGDP (F-E RGDP)

2. Actual Unemployment Rate = The Natural Rate of Unemployment (NRU) or the Non-Accelerating Inflation Rate of Unemployment (NAIRU)

3. We assume Price Stability at “PL*”

Any deviation from Point “A” is going to create a different relationship between Inflation and Unemployment.

Page 5: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

If we take this Inflation Rate and UnemploymentRate and plot it on our Phillips Curve Graph, we haveOur first point on our Phillips Curve—Point “A”

Page 6: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”

UR 1

Assume AD INCREASES and shiftsTo the RIGHT.

The new equilibrium is Point “B” at “PL1” and “RGDP 1”.

Inflation has INCREASED (“Demand-Pull”)RGDP has INCREASEDUnemployment has DECREASED

Page 7: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”I 1

UR 1

If we plot this new relationshipBetween Inflation and Unemployment,We are now at Point “B” on the Phillips Curve HIGHER and to the LEFT of “A”

Inflation increased from “I* to I1” and Unemployment Decreased from “UR* to UR1”

Page 8: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”I 1

UR 1

Notice the INVERSE relationship between Inflation and Unemployment that occurred as AD shifted to the RIGHT.

Page 9: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

PL 1

RGDP 1

“B”

UR 1 RGDP 2

PL 2

Lets keep Point “B” on thePhillips Curve and start over on the AD/AS graph and see what happens If AD DECREASES.

Page 10: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

PL 1

RGDP 1

“B”

RGDP 2

PL 2

“C”

AD 2

AD DECREASES and shifts to the LEFT.

New equilibrium at Point “C” withA lower level of Inflation “PL2” and a higher level of Unemployment that Accompanies a lower level or RGDP (“RGDP2”)

Page 11: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

PL 1

“B”

UR 1 RGDP 2

PL 2

UR 2

I 2“C” “C”

AD 2

If we plot this point on our Phillips Curve we can establish Point “C”, that illustrates Inflation DECREASING from “I* to I2” andUnemployment INCREASING from UR*To “UR2”. It is down and to the right of “A”

Page 12: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

PL 1

“B”

UR 1 RGDP 2

PL 2

UR 2

I 2“C” “C”

AD 2

Once again, note the INVERSERelationship between InflationAnd Unemployment that occurred asAD DECREASED and shifted to the LEFT

Page 13: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”I 1

UR 1 RGDP 2

PL 2

UR 2

I 2“C” “C”

AD 2

Lets re-insert the AD shifts on the Graphs to the right.

We have established 3 core points on our Phillips Curve Graph which we Derived from the AD shifts- either to the left or to the right ALONG our FIXED SRAS curve.

Each shift, RELATIVE to the starting point At Full-Employment, represents a change in the Relationship between Inflation and Unemployment

Page 14: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”I 1

UR 1 RGDP 2

PL 2

UR 2

I 2“C” “C”

AD 2

To finish out our Phillips Curve we need to look at the 2 extremes and see what happens to the relationship between Inflation and Unemployment if AD 1 curve kept increasing and shifting to the RIGHT or AD 2 is kept decreasing and shifting to the LEFT

Page 15: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”I 1

UR 1 RGDP 2

PL 2

UR 2

I 2“C” “C”

AD 2

If AD 1 Curve continued to shift to the RIGHT we would produce no more RGDP, hence the Unemployment Rate would not drop any further.

We would have no decrease in unemployment, but we would have increasing Inflation.

This is represented by the VERTICAL section of the Phillips Curve

Page 16: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”

UR 1 RGDP 2

PL 2

UR 2

“C” “C”

AD 2SRPC*

If AD 2 Curve continued to shift to the LEFT we would continue to have a decrease in RGDP and an increase in Unemployment BUT the Inflation would eventually level out because “stuff “would never be produced below certain prices.

We would have a continued decrease in unemployment, but we would have a bottoming out of Inflation

This is represented by the HORIZONTAL section of the Phillips Curve

Page 17: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

UR*(NRU)

AD 1

PL 1

RGDP 1

“B”“B”

UR 1 RGDP 2

PL 2

UR 2

“C” “C”

AD 2SRPC*

“Short RunPhillips Curve”

Connect the dots and we have a “SHORT RUN PHILLIPS CURVE”

Page 18: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Short Run Phillips Curve

Represents the trade-off between Inflation and Unemployment as AD increases or decreases ALONG the Fixed Short Run Aggregate Supply Curve

Page 19: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

What SHIFTS the Short Run Phillips Curve (SRPC) to the Left or to the Right?

Short Run Aggregate Supply Shocks!

A NEGATIVE SUPPLY shock (SRAS shifts to the LEFT) will shift the SRPC to the RIGHT!

A POSITIVE SUPPLY shock (SRAS shifts to the RIGHT) will shift the SRPC to the LEFT

Page 20: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

Let start over to illustrate how a Shift in the SRAS curve will cause aShift of the Phillips Curve.

For simplicity I will take out the LRAS, but Understand it still exits.

Page 21: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

Page 22: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

PL 1

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

“B”

Assume a Negative Supply Shock

SRAS curve shifts to the LEFT and we establish a new equilibrium aAt Point “B”—”COST PUSH INFLATION”

Price Level INCREASESRGDP DECREASESUnemployment INCREASES

Opps!---this does not conform to our nice and neatINVERSE relationship between Inflation and Unemployment.It appears now to be a DIRECT relationship

Page 23: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

PL 1

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

“B”

Notice Point “B” on AD/AS is at a HIGHERLevel of Inflation AND a HIGHER level Of Unemployment RELATIVE to Point “A”.If we plot this point on the Phillips Curve GraphWe will find that point is ABOVE and to the LEFT of “A”

“B”

Page 24: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

PL 1

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

“B”

We have established ONE Inflation/Unemployment Point that now lies to the RIGHT of the SRPC*.

“B”

Page 25: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

PL 1

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

“B”

If policies were implemented to shift AD either to the LEFT or RIGHT we would create a NEW Phillips Curve that lies to the RIGHT of the previous one (SRPC*)

“B”

Page 26: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

PL 1

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

“B”“B”

SRPC 1

Helpful Hint: If SRAS curve shifts to the LEFTThen the Phillips Curve will shift to the RIGHT

Page 27: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

UR*(NRU)

UR 1 UR 2

SRPC*

SRAS 1

RGDP 1

SRPC 1

How it looks cleaned up!!

Page 28: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

What happens to the Phillips Curve If there is a POSTIVE Supply Shock?

Page 29: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

PL 1

“B”

Assume a Positive Supply Shock

SRAS curve shifts to the RIGHT and we establish a new equilibrium aAt Point “B”

Price Level DECREASESRGDP INCREASESUnemployment DECREASES

Opps!---this does not conform to our nice and neatINVERSE relationship between Inflation and Unemployment.It appears now to be a DIRECT relationship

Page 30: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

PL 1

“B”“B”

Notice Point “B” on AD/AS is at a LOWERLevel of Inflation AND a LOWER level of Unemployment RELATIVE to Point “A”.If we plot this point on the Phillips Curve Graphwe will find that point is BELOW and to the LEFT of “A”

Page 31: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

PL 1

“B”“B”

We have established ONE Inflation/Unemployment Point that now lies to the LEFT of the SRPC*.

Page 32: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

PL 1

“B”“B”

If policies were implemented to shift AD either to the LEFT or RIGHT we would create a NEW Phillips Curve that lies to the LEFT of the previous one (SRPC*)

SRPC 1

Page 33: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

UR*(NRU)

“B”

UR 1 UR 2

“C”

SRPC*

SRAS 1

RGDP 1

PL 1

“B”“B”

SRPC 1

Helpful Hint: If SRAS curve shifts to the RIGHTThen the Phillips Curve will shift to the LEFT

Page 34: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD

Phillips Curve

Inflation

Unemployment

UR*(NRU)

UR 1 UR 2

SRPC*

SRAS 1

RGDP 1

SRPC 1

Here is how it looks cleaned up!

Page 35: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Long Run Phillips Curve

Easy, Cheesey!!

In the long run, there is no trade off between Inflation and Unemployment

Page 36: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

AD*

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

We will start out at our neutral position.

The NRU and Price Stability---the “NAIRU”

Page 37: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

AD 1

RGDP 1

PL 1

“B”

Assume AD increases and shifts to the RIGHT.

Price Level INCREASESRGDP INCREASESUnemployment DECREASES

Our new equilibrium is at Point “B” (note this!)Absent any policy interventions we will see how the “Self-Correcting Mechanism” will work to get the economy back to full-employment

Page 38: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

AD 1

RGDP 1

PL 1

“B”

We already know that this movement along the SRAS CurveIN THE SHORT RUN and will create movement ALONG a Short Run Phillips Curve (Up and to the Left).

However, now we want to transition to the LONG RUN situation.

Page 39: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

AD 1

RGDP 1

PL 1

“B”

The economy is experiencing INFLATION AND the Actual Unemployment Rate is now BELOW the NRU.

This going to create conditions for “Wage Inflation”

Remember: Wages are an input into the Cost of Producing

When input prices INCREASE what happens to SRAS?

Page 40: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

AD 1

RGDP 1

PL 1

“B”

SRAS 1

“C”

PL 2

A NEGATIVE SUPPLY SHOCK.

SRAS shifts to the LEFT

Price Level INCREASESRGDP DECREASESUnemployment DECREASES

New Equilibrium after the LONG TERM ADJUSTMENT is at Point “C”

NOTE:We have returned to Full-employment RGDP and the NRUBUT at a HIGHER Price Level than before

Page 41: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

AD 1

RGDP 1

PL 1

“B”

SRAS 1

“C”

PL 2

“C”

I1

Plot Point “C” from AD/AS on the Phillips Curve

Page 42: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

AD 1

RGDP 1

PL 1

“B”

SRAS 1

“C”

PL 2

“C”

I1

Point “C” represents belowRepresents a HIGHER Price Level back at the NRU

Page 43: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Now, Let’s look at it from the perspective of a DECREASE in AD

Page 44: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*

“C”

I1

We will start out at our neutral position.

The NRU and Price Stability---the “NAIRU”

Page 45: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*PL 1

PL 2

“C”

RGDP 1

AD 1

“B”

Assume AD decreases and shifts to the LEFT.

Price Level DECREASESRGDP DECCREASESUnemployment INCREASES

Our new equilibrium is at Point “B” (note this!)Absent any policy interventions we will see how the “Self-Correcting Mechanism” will work to get the economy back to full-employment

Page 46: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*PL 1

“C”

RGDP 1

AD 1

“B”

The economy is experiencing RECESSIONAND the Actual Unemployment Rate is now ABOVE the NRU.

This going to create conditions for “Wage Deflation”

Remember: Wages are an input into the Cost of Producing

When input prices DECREASE what happens to SRAS?

Page 47: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*PL 1

PL 2

“C”

I1

RGDP 1

AD 1

SRAS 1

“C”

“B”

A POSITIVE SUPPLY SHOCK.

SRAS shifts to the RIGHT

Price Level DECREASESRGDP INCREASESUnemployment DECREASES

New Equilibrium after the LONG TERM ADJUSTMENT is at Point “C”

NOTE:We have returned to Full-employment RGDP and the NRUBUT at a LOWER Price Level than before

Page 48: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”“A”

LRAS

I*

UR*(NRU)

AD*PL 1

RGDP 1

AD 1

SRAS 1

“C”

“B”

PL 2

“C”I2

Plot Point “C” from AD/AS on the Phillips Curve

Page 49: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”

LRAS

UR*(NRU)

AD*

LRAS*

I*“A”

If we connect our points on the PHILLIP CURVEWe will derive the LONG RUN PHILLIPS CURVE

Page 50: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Aggregate Demand/Aggregate Supply

PriceLevel

Quantity of Real GDP

FeRGDP

SRAS

PL*

Phillips Curve

Inflation

Unemployment

“A”

LRAS

UR*(NRU)

AD*

LRAS*

I*“A”

The Long Run Phillips Curve suggests There is ON Long Term Trade-off betweenInflation and Unemployment

Page 51: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

What can shift the LONG RUN PHILLIPS CURVE?

Anything that might change the Natural Rate of Unemployment

Remember: The NRU is comprised ofa. Frictional Unemploymentb. Structural Unemployment

Policies that INCREASE these types of unemployment will INCREASEthe NRU and the LONG RUN PHILLIPS CURVE will shift to the RIGHT.

Policies that DECREASE these types of unemployment will DECREASEthe NRU and the LONG RUN PHILLIPS CURVE will shift to the LEFT

1. A change is government benefits for the unemployed—incentives or dis-incentives to work2. A change in education/skill level of the population3. An increase in Labor and Capital (Technology) Productivity

Page 52: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

Phillips Curve and The short and long terms effects of inflaton.

• We will use as an example a sub-topic from the #1 FRQ from the 2009 AP Macroeconomics Test

Page 53: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

The INFLATION RATE currently is 6% and the Federal Reserve believes that is too HIGH.They decide to target 3% as a “preferred” level of Inflation.

LRAS

Page 54: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENTNRU

SRPC

LRPC

6%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

In order to DECREASE INFLATION the Federal Reserve would carry out the Open Market Operation or SELLING BONDS---this will DECREASE the Money Supply andINCREASE the FEDERAL FUNDS RATE and tend to INCREASE INTEREST RATES throughout the Financial System.

Page 55: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

INCREASING INTEREST RATES will cause AD to DECREASE

AD1

RGDP1

PL1

Page 56: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

REAL GDP will DECREASE AND PRICE LEVEL (inflation) will DECREASE AND Because RGDP DECREASES, UNEMPLOYMENT will INCREASE

AD1

RGDP1

PL1

Page 57: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

INFLATION is DECREASING and UMEPLOYMENT IS INCREASING---There is MOVEMENT ALONG THE PHILLIPS CURVE IN THE SHORT RUN

AD1

RGDP1

PL1

UR1

Page 58: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

The Economy settles at a LOWER INFLATION RATE and a HIGHER UNEMPLOYMENT RATE…

AD1

RGDP1

PL1

UR1

Page 59: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

NOTE: This is the situation in the “SHORT-RUN”---What is the LONG-TERM EFFECT of the Federal Reserves action?

AD1

RGDP1

PL1

UR1

Page 60: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

People (and business and govt) EXPECTIONS about INFLATION are now going toBe “built-in”---They have expectations of LOWER PRICES AND WAGES….

AD1

RGDP1

PL1

UR1

Page 61: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

This will affect a number of things BUT lets focus on WAGES

AD1

RGDP1

PL1

UR1

Page 62: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

Because there are expectations of LOWER Inflation then WAGES tend to Stabilize and MAY decrease (assume this to be the case)…On the AD/AS Graph, which curve is going to be affected???

AD1

RGDP1

PL1

UR1

Page 63: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

Aggregate Supply!! Cost of Production will tend to DECREASE…When C.O.P DECREASES then Aggregate Supply will INCREASE (Shift to the Right)

AD1

RGDP1

PL1

UR1

SRAS1

RGDP2

PL2

Page 64: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

Price Level (inflation) has DECREASED and RGDP has INCREASED (back to the original FE FGDP* therefore UNEMPLOYMENT has DECREASED.

AD1

RGDP1

PL1

UR1

SRAS1

RGDP2

PL2

Page 65: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

How does this affect the Phillips Curve??? When the SRAS curve shifts to the RIGHTThe Short-Run Phillips Curve shifts to the LEFT!! Now at every level of UNEMPLOYMENT the PRICE LEVEL will be LOWER.

AD1

RGDP1

PL1

UR1

SRAS1

PL2

RGDP2

Page 66: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

INFLATION

UNEMPLOYMENT

NRU

SRPC

LRPC

6%

3%

PriceLevel

RGDP

SRAS

AD*

RGDP*

PL*

With the shift of The Short Run Phillips Curve we move back to Long-Run Equilibrium where SRPC intersect LRPC at the NRU….THE LONG RUN PHILLIPS CURVE IS NOT GOING TO SHIFT.

AD1

RGDP1

PL1

UR1

SRAS1

RGDP2

PL2

Economy is BACK to FE where AD = SRAS=LRASWe are STILL at the NRU but at a LOWER IINFLATION RATE!!

Page 67: PHILLIPS CURVE. Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation.

The End