Transcript Phillips curve

Unit 3:
Aggregate Demand and
Supply and Fiscal Policy
1
Review
1. Draw an Inflationary Gap with your fingers.
2. Draw a Recessionary Gap with your fingers.
3. What is the self-correcting mechanism that
will bring an inflationary gap back to
equilibrium?
4. What is the self-correcting mechanism that
will bring a recessionary gap back to
equilibrium?
5. What does a negative supply shock do?
6. Name the factors that shift SRAS
7. Name Universities in Idaho.
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3.4 The Phillips Curve
Shows tradeoff between inflation and
unemployment.
What happens to inflation and unemployment
when AD increase?
In general, there is an inverse relationship
between unemployment and inflation
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Unemployment and Inflation
in the US 1955-1968
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Short Run Phillips Curve
When the economy is overheating, there is low
unemployment but high inflation
Inflation
When there is a recession,
unemployment is high but
inflation is low
5%
1%
SRPC
2%
9%
Unemployment
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Short Run Phillips Curve
What happens when AS falls causing stagflation?
Increase in unemployment and inflation
Inflation
5%
SRPC1
1%
SRPC
2%
9%
Unemployment
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Short Run vs. Long Run
In the long run there is no tradeoff between inflation
and unemployment
Inflation Long Run Phillips Curve
5%
The LRPC is vertical at
the Natural Rate of
Unemployment
3%
1%
2%
5%
9%
Unemployment
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The Phillips Curve in real life isn’t like the textbook
Draw the short-run Phillips curve
and the long-run Phillips curve.
Explain why they are different
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• In the short run, monetary policy can affect the unemployment
rate
– an increase in the growth rate of money raises actual inflation above
expected inflation, causing firms to produce more since the SRAS is
positively sloped
• In the long run monetary policy has no effect on unemployment,
which tends toward its natural rate
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AD/AS and the
Phillips Curve
THE PHILLIPS CURVE
The Phillips curve shows the short-run trade-off
between inflation and unemployment.
How the Phillips Curve is
Related to Aggregate Demand
and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
102
Inflation
Rate
(percent
per year)
Short-run
aggregate
supply
6
B
106
B
A
High
aggregate demand
Low aggregate
demand
0
(b) The Phillips Curve
7,500
(unemployment
is 7%)
8,000
(unemployment
is 4%)
Quantity
of Output
A
2
Phillips curve
0
4
(output is
8,000)
Unemployment
7
(output is Rate (percent)
7,500)
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF EXPECTATIONS
• The Phillips curve seems to offer policymakers
a menu of possible inflation and
unemployment outcomes.
The Long-Run Phillips Curve
• In the 1960s, Friedman and Phelps
concluded that inflation and unemployment
are unrelated in the long run.
– As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
Increasing the money supply will shift AD—
raising prices and lowering unemployment
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The Long-Run Phillips Curve
Inflation
Rate
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
High
inflation
Low
inflation
0
Long-run
Phillips curve
B
A
Natural rate of
unemployment
2. . . . but unemployment
remains at its natural rate
in the long run.
Unemployment
Rate
The Meaning of “Natural”
• The “natural” rate of unemployment is the
rate to which the economy gravitates in the
long run.
• The natural rate is not necessarily desirable,
nor is it constant over time.
• Monetary policy cannot change the natural
rate, but other government policies that
strengthen labor markets can.
How the Phillips Curve is
Related to Aggregate Demand
and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level
P2
2. . . . raises
the price
level . . .
P
Inflation
Rate
Long-run aggregate
supply
B
(b) The Phillips Curve
Long-run Phillips
curve
3. . . . and
increases the
inflation rate . . .
1. An increase in
the money supply
increases aggregate
demand . . .
B
A
A
AD2
Aggregate
demand, AD
0
Natural rate
of output
Quantity
of Output
0
4. . . . but leaves output and unemployment
at their natural rates.
Natural rate of
unemployment
Unemployment
Rate
The Short-Run Phillips Curve
• Expected inflation measures how much
people expect the overall price level to
change
– If employees think there will be high inflation,
they will ask for a higher wage in their
employment contract
– If employers think there will be high inflation
they will be willing to pay a higher wage,
because it will still be cheaper than having to
hire someone later
• In the long run, expected inflation adjusts to
changes in actual inflation.
How Expected Inflation Shifts the ShortRun Phillips Curve
Inflation
Rate
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Long-run
Phillips curve
C
B
Short-run Phillips curve
with high expected
inflation
A
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
0
Short-run Phillips curve
with low expected
inflation
Natural rate of
unemployment
Unemployment
Rate
The Natural Experiment for the
Natural-Rate Hypothesis
• The view that unemployment eventually returns to
its natural rate, regardless of the rate of inflation,
is called the natural-rate hypothesis.
• Historical observations support the natural-rate
hypothesis.
• The concept of a stable Phillips curve broke down
in the in the early ’70s.
• During the ’70s and ’80s, the economy
experienced high inflation and high
unemployment simultaneously.
The Breakdown of the Phillips Curve in the
1970s
Inflation Rate
(percent per year)
10
8
6
1973
1971
1969
1968
4
1970
1972
1967
2
0
1966
1962
1965
1964
1963
1
2
3
4
5
6
1961
7
8
9
10 Unemployment
Rate (percent)
AD/AS and the Phillips Curve
Show what happens on both graphs if AD increase
Price
Level
LRAS
Inflation
LRPC
AS
PLe
AD1
AD
QY
GDPR
SRPC
UY
Unemployment
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AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with the
recessionary gap. What happens when AD falls?
Price
Level
LRAS
Inflation LRPC
AS
PLe
AD
AD1
QY GDPR
SRPC
UY
Unemployment
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AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC at full
employment. What happens when AS falls?
Price
Level
LRAS
Inflation
LRPC
AS1
AS
PLe
SRPC1
AD
QY
GDPR
SRPC
UY
Unemployment
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AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with an
recessionary gap. What happens when AS goes up?
Price
Level
LRAS
AS
Inflation
LRPC
AS1
PLe
SRPC
AD
QY
GDPR
SRPC1
UY
Unemployment
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Draw three AD & AS curves and three
short-run and long-run Phillips Curves
Price Level
LRAS
SRAS
Inflation
LRPC
SRPC
QY
GDPR
UY Unemployment
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Price Level
SRAS
LRAS
Inflation
LRPC
PLe
AD
AD3
QY
GDPR
AD2
SRPC
UY Unemployment
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Price Level
LRAS
AS1
SRAS
Inflation
LRPC
AS2
PLe
SRPC1
AD
QY
GDPR
SRPC2
SRPC
UY Unemployment
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Price Level
LRAS AS2
AS
Inflation
LRPC
PLe
AD2
AD
QY
GDPR
SRPC1
SRPC
UY Unemployment
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Analyzing the Economy
Graphically
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Use the following models to show full
employment, a recessionary gap, and an
inflationary gap.
1. PPC
2. Business Cycle
3. AD/AS
4. Phillips Curve
The Good, the Bad, and the Ugly
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less
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