Transcript The Phillips Curve

The Phillips Curve
• When engaged in a lesson on the Phillip's
Curve, the learner will compare and contrast
the philip's curve to the aggregate
supply/aggregate demand curve, in order to
fully understand why there is an inverse
relationship between inflation and
unemployment. The Phillip's Curve will be
presented in an active board lesson and
student participation, with 100 percent
mastery.
The extended AS/AD model supports three
generalizations:
• In the short-run, there is a trade-off between
the rate of inflation and the rate of
unemployment.
• AS shocks can cause both higher rates of
inflation & higher rates of unemployment.
• In the long run, there is no significant tradeoff between inflation and unemployment.
Price Level
This first generalization can be seen by shifting the AD curve
to the right. What would be the affect upon
output/employment AD1
SRAS
and upon price
levels if AD shifted
from AD1 to AD4?
PL1
0
Y1
Real domestic output
Price Level
AD1
AD2
SRAS
PL2
PL1
o
Y1
Y2
Real domestic output
Price Level
AD1
AD2
AD3
SRAS
PL3
PL2
PL1
o
Y1
Y2
Y3
Real domestic output
Assuming a
constant SRAS
curve, we see
that high
PL4
inflation is
accompanied
PL3
by low
unemployment.
PL
AD1
AD2
AD3
AD4
SRAS
2
PL1
o
Y1
Y2
Y3 Y4
Real domestic output
We can demonstrate this short run trade off
between inflation and unemployment by
using the Phillips Curve.
7
6
5
Annual rate
of inflation
4
3
2
SRPC
1
0
1
2
3
4
5
6
7
Unemployment rate (percent)
Phillips Curve – there is an inverse relationship
between inflation and unemployment. As inflation
decreases, unemployment increases.
Annual rate of inflation
7
6
5
4
3
2
1
0
1
2
3
4
5
6
7
Unemployment rate (percent)
The short-run Phillips Curve is an inverse of the
SRAS curve. A rightward shift of AD moves up the
SRAS curve; which also moves up the SRPC.
Phillips curve
SRAS
AD3
AD2
AD1
C
B
A
REAL OUTPUT
INFLATION RATE
PRICE LEVEL
AS/AD
SRPC
C
B
A
UNEMPLOYMENT RATE
During the 1960s the Phillips Curve
Revealed a stable relationship
between inflation and unemployment.
But during the 1970s and early 1980s this idea of an
always-stable Phillips Curve was destroyed. In those
years’ inflation and unemployment rose simultaneously
(stagflation). So this period proved our second
generalization that AS shocks can cause both higher
inflation and higher unemployment.
A leftward shift of AS, causing stagflation, equals a
rightward shift of the SRPC.
PRICE LEVEL
SRAS2
SRAS1
AD1
B
A
REAL OUTPUT
Phillips curve
INFLATION RATE
AS/AD
SRPC1 SRPC2
B
A
UNEMPLOYMENT RATE
The economy
recovered from this
period of stagflation
when the Chairman
of the FED, Paul
Volker, followed a
tight money policy
aimed at reducing
double-digit inflation
(13% in 1979).
Unemployment rose
to 9.5%; but by 1983
inflation was under
control (3.7%), Ig was
increasing, and AD
rose.
Increasing AD beyond FE may temporarily
increase GDP/Y/employ.
Phillips curve
SRAS1
LRAS
AD2
AD1
B
A
FE
REAL OUTPUT
INFLATION RATE
PRICE LEVEL
AS/AD
SRPC1
LRPC
B
A
NRU
UNEMPLOYMENT RATE
But when nominal wages eventually catch up
profits will fall, ending the stimulus to produce
beyond FE.
AD2
AD1
Phillips curve
LRAS SRAS2
SRAS1
C
B
A
FE
REAL OUTPUT
INFLATION RATE
PRICE LEVEL
AS/AD
SRPC1
SRPC2
LRPC
B
C
A
NRU
UNEMPLOYMENT RATE
So there is no tradeoff between the rates of inflation and
unemployment in the long-run. Like the LRAS curve, the LRPC is a
vertical line at the economy’s natural rate of unemployment (5%).
LRPC
SRPC3
12%
Inflation
c3
SRPC2
8%
4%
0
b3
c2
b2
SRPC1
C1
2%
Inflat.
Gap
3%
Recess.
Gap
b1
5%
8%
Unemployment
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