Transcript Phillips Curve

AP Macro
The Phillips Curve

In a 1958 paper, New Zealand born economist, A.W.
Phillips published the results of his research on the
historical relationship between the unemployment rate
(u%) and the rate of inflation (π%) in Great Britain.
His research indicated a stable inverse relationship
between the u% and the π%. As u%↓, π%↑ ; and as
u%↑, π%↓. The implication of this relationship was
that policy makers could exploit the trade-off and
reduce u% at the cost of increased π%. The Phillips
curve was used as a rationale for the Keynesian
aggregate demand policies of the mid-20th century.
A.W. Phillips

It’s customary in a presentation to include
the picture of the person whose work is
being studied. I didn’t have much luck, but
here’s what I’ve got.
I like to think
that Phillips
looked like
this. Thanks
Google.
The Phillips Curve
(hypothetical example)
π%
4%
2%
. .
.
. ..
5%
7%
.
PC
u%
Note: Inflation Expectations are held constant
Trouble for the Phillips Curve

In the 1970’s the United States experienced
concurrent high u% & π%, a condition known as
stagflation. 1976 American Nobel Prize economist
Milton Friedman saw stagflation as disproof of the
stable Phillips Curve. Instead of a trade-off between
u% & π%, Friedman and 2006 Nobel Prize recipient
Edmund Phelps believed that the natural u% was
independent of the π%. This independent relationship
is now referred to as the Long-Run Phillips Curve. I
believe it’s relevant that by this time the BrettonWoods system had collapsed.
Trouble for the Phillips Curve
π%
4%
2%
.
. .
. ..
.
. . .
. ..
.
5%
7%
.
PC
u%
Trouble for the Phillips Curve
π%
4%
2%
LRPC
.
. .
. ..
. . .
. ..
.
5%
un% 7%
.
u%
The Long-Run Phillips Curve
π%
LRPC
un %
u%
Note: Natural rate of unemployment is held constant
The Long-Run Phillips Curve
(LRPC)
Because the Long-Run Phillips Curve
exists at the natural rate of
unemployment (un), structural changes
in the economy that affect un will also
cause the LRPC to shift.
 Increases in un will shift LRPC 
 Decreases in un will shift LRPC 

The Short-Run Phillips Curve
(SRPC)

Today many economists reject the concept of a
stable Phillips curve, but accept that there may be
a short-term trade-off between u% & π% given
stable inflation expectations. Most believe that in
the long-run u% & π% are independent at the
natural rate of unemployment. Modern analysis
shows that the SRPC may shift left or right. The
key to understanding shifts in the Phillips curve is
inflationary expectations!
The Short-Run Phillips Curve (SRPC)
π%
4%
2%
.
. .
. ..
.
. . .
. ..
5%
7%
.
SRPC
u%
The Short-Run Phillips Curve (SRPC)
π%
4%
2%
.
. .
. ..
.
. . .
. ..
5%
7%
SRPC1
.
SRPC
u%
Reconciling the LRPC and SRPC
LRPC
π%
π1 %
B 
C
A
π%
In the short-run,
Assume
long-run,
that either
the
assuming
the
inflationthe
rate at is
B successful,
(π1 %)
government
policy
or the central
inflation
becomes
bank
occurs
enacts
and
the
unemployment
an
new
expansionary
expected
^%),
inflation
policy
decreases
to rate
reduce
as(π
the
economy
and the
1 the
unemployment
moves
from
A torate
B.
economy
returns
to below
the its
natural
A.
natural rate
rate at
of point
unemployment
(point C).
SRPC (π1^ %)
SRPC (π^ %)
u%
u N%
u%
Reconciling the LRPC and SRPC
π%
π1 %
In theassume
Now
long-run,
short-run,
that
the
assuming
either
inflation
thethe
rate at is
B successful,
(π1 %)
government
policy
or the central
becomes
bank
disinflation
enacts
the
occurs
anew
contractionary
expected
and
^inflation
inflation
policy
unemployment
to rate
reduce
(π1increases
%), and the
from
as
it’s
the
current
economy
rate
moves
atagain,
point
from
A A to
economy,
once
B.
returns to the natural rate of
unemployment (point C).
A
C

π%
LRPC
B
SRPC (π^ %)
SRPC (π1^ %)
u N%
u%
u%
Relating Phillips Curve to AS/AD
Changes in the AS/AD model can also be seen in the
Phillips Curves
 An easy way to understand how changes in the
AS/AD model affect the Phillips Curve is to think of
the two sets of graphs as mirror images.
 NOTE: The 2 models are not equivalent. The AS/AD
model is static, but the Phillips Curve includes change
over time. Whereas AS/AD shows one time changes
in the price-level as inflation or deflation, The Phillips
curve illustrates continuous change in the price-level
as either increased inflation or disinflation.

Increase in AD = Up/left movement
along SRPC
PL
SRAS
SRPC

π1
π


P1
..
AD1
AD

Y
YF

P
.
.
LRAS
π%
GDPR
un
u
C↑, IG↑, G↑ and/or XN↑
.: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
u%
Decrease in AD = Down/right along
SRPC
LRAS
PL

P1
.
SRAS
SRPC
π

.

P
π%
.
.
π1
AD
AD1

YF
Y

GDPR
u
un
u%
C↓, IG↓, G↓ and/or XN↓
.: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC
SRAS  = SRPC 
PL
LRAS
.
P1
Y
YF
LRPC
π1
.
GDPR
un
π
AD

SRPC1


.
SRAS1

SRPC
.

P
π%

SRAS
u
u%
Inflationary Expectations↓, Input Prices↓, Productivity↑,
Business Taxes↓, and/or Deregulation
.: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC  (Disinflation)
Summary

There is a short-run trade off between u% & π%. This is
referred to as a short-run Phillips Curve (SRPC)

In the long-run, no trade-off exists between u% & π%. This is
referred to as the long-run Phillips Curve (LRPC)

The LRPC exists at the natural rate of unemployment (un).
 un ↑ .: LRPC 
 un ↓ .: LRPC 

ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC
 AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
 AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ
Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC
 SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC 
 SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC 
Arthur Laffers Curve
The Laffer Curve

Arthur Laffer is a supply side economist
who became influential during the
Reagan administration as a member of
Reagan's Economic Policy Advisory
Board (1981-1989).
Supply Side Economics Based
idea

Reductions in marginal tax rates
increase the nation’s aggregate supply.

The Laffer Curve depicts the relationship
between tax rates and tax revenues.
Laffer Curve

As tax rates ↑ from
0 - 100%, tax
revenues increase
from zero to some
maximum level then
fall to zero.
Laffer Curve
Tax revenues decline beyond some point
because higher tax rates discourage
economic activity, therefore shrinking the
tax base.
 When taxes are lower, tax avoidance and
tax evasion is less.

If tax rate is 100%, revenue is reduced to
zero because a 100% rate has halted
production.
 A 100% tax rate=0 revenue

Criticisms of the Laffer
The degree economic incentives are
sensitive to changes in the tax rate.
↓ taxes encourages others to work more, while
some work less.
↓after tax pay encourages ↑work,
↑ after tax pay encourages ↓work.
2. Inflation-demand side effects of a tax cut
exceed the supply-side effects. Demand pull
inflation is likely.
3. Position on the curve-an economies position
on the curve is undocumented and unknown.
1.