Transcript Aggregate Supply in the Short and Long Run

Aggregate Supply and the
Phillips Curve
AD/AS and the Phillips Curve
• The Aggregate Demand/Supply Model illustrates
the short-run relationship between price level
and employment. As price level rises,
employment increases.
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment. As price level rises,
unemployment decreases.
• Movement up along the supply curve is mirrored
by movement up along the Phillips curve.
How the Phillips Curve is Related to the Model
of Aggregate Demand and Aggregate Supply
in the Short-run
(a) The Model of AD and AS
Price Level
SRAS
106
B
102
Inflation Rate
(% per year)
High AD
A
7,500
8,000
B
6
A
2
Low AD
0
(b) The Phillips Curve
Output
0
Phillips curve
4
7
Unemployment
Rate (%)
Shifts in the Phillips Curve: The Role of
Supply Shocks
The short-run Phillips curve shifts because of shocks
to aggregate supply.
A supply shock is an event that directly affects
firms’ costs of production and thus their ability to
produce.
An increase in the price of oil increases production
costs and forces employers to lay off workers.
This is shown by a leftward shift of the AS curve and
an upward shift of the Phillips curve (higher prices
and higher unemployment)
A positive supply shock would move AS to the
right and shift the Phillips curve downward- lower
prices and lower unemployment
An Adverse Shock to Aggregate Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
3. …and raises the
price level…
(b) The Phillips Curve
Inflation
Rate
AS2 Aggregate
supply, AS1
P2
A
P1
B
1. An adverse
shift in aggregate
supply…
B
A
PC2
Aggregate
demand
0
Y2
Y1
2. …lowers output…
Quantity of
Output
4. …creating a less
favorable tradeoff
between unemployment
and inflation.
0
Phillips curve, PC1
Unemployment Rate
The Long Run Phillips Curve
• The Long Run Phillips Curve illustrates the Natural
Rate of Unemployment
• Changes in price level do not affect the LRPC, but
the LRPC can change (shift) if there are changes
in:
–
–
–
–
–
Minimum wage
Collective bargaining laws
Unemployment insurance
Job training programs
Job search assistance
The Long-Run Phillips Curve...
Inflation
Rate
0
LRPC1
LRPC2
Natural rate of
unemployment
Unemployment
Rate
Expectations and the
Short-Run Phillips Curve
 Expected inflation measures how much
people expect the overall price level to
change.
 It is shown graphically as the point on the
Short-run Phillips Curve that intersects the
Long-run Phillips Curve.
Expected Inflation & Actual Inflation
Long-run
Phillips Curve
Inflation
Rate
B
6%
4%
Expected Rate of
Inflation
A
C
0
Natural Rate of
Unemployment
Unemployment
Rate
Expectations and the Short-run Phillips Curve
• If actual inflation is higher than expected
inflation then unemployment decreases.
• This is shown by movement upward and along
a stable Phillips Curve.
• If actual inflation is lower than expected
inflation then unemployment increases,
movement down along the PC.
• In both instances we deviate from the natural
rate of unemployment.
Expected Inflation & Actual Inflation
Long-run
Phillips Curve
Inflation
Rate
Actual Rate of
Inflation
B
6%
4%
Expected Rate of
Inflation
A
C
0
Natural Rate of
Unemployment
Unemployment
Rate
Expectations and the
Short-Run Phillips Curve
 In the long run, expected inflation adjusts to
•
•
•
changes in actual inflation.
--This is shown by a shift in the entire short-run
Phillips Curve.
--If inflationary expectations are now higher the
curve shifts right. This shows a worsening tradeoff between inflation and unemployment.
--If inflationary expectations are now lower the
curve shifts left. This is an improvement in the
trade-off.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How Expected Inflation Shifts the Short-Run
Phillips Curve...
Inflation
Rate
Long-run
Phillips curve
B
1. Expansionary
policy moves
the economy up
along the shortrun Phillips
curve...
0
2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
curve shifts to the right.
C
Short-run Phillips curve with
high expected inflation
A
Short-run Phillips curve with
low expected inflation
Natural rate of
unemployment
Unemployment
Rate