The Phillips Curve AP Macroeconomics

Expansionary Monetary Policy Money Market Loanable Funds Market Expansionary Monetary Policy

Contractionary Monetary Policy Money Market Loanable Funds Market Contractionary Monetary Policy

Expansionary Fiscal Policy Loanable Funds Market Money Market Expansionary Fiscal Policy

Contractionary Fiscal Policy Loanable Funds Market Money Market Contractionary Fiscal Policy

Inflation, deflation, disinflation Demand-pull inflation Cost-push inflation Inflation, deflation, disinflation

The Phillips Curve 1958 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%↓. Implication: policy makers could exploit the trade-off and reduce u% at the cost of increased π%. Used as a rationale for the Keynesian aggregate demand policies of the mid-20th century.

The Phillips Curve (hypothetical example) π% . . . 4% . . . 2% . PC 5% 7% u% Note: Inflation expectations are held constant

AD1 5% AD2 1% 3%

Relating Phillips Curve to AS/AD 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 AD = ↑/← along SRPC PL π% LRAS . . SRAS SRPC  . . P1 π 1    P π AD1 AD   Y YF GDPR un u u% C↑, IG↑, G↑ and/or XN↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC

Decrease AD = ↓/→along SRPC PL LRAS π% . SRAS SRPC .  . . P π    P1 π1 AD AD1   YF Y GDPR u un u% C↓, IG↓, G↓ and/or XN↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

Trouble for the Phillips Curve 1970’s the United States experienced concurrent high u% & π%, stagflation. 1976 American Nobel Prize economist Milton Friedman saw stagflation as disproof of the stable Phillips Curve. Natural u% was independent of the π%. This independent relationship is called the Long-Run Phillips Curve.

Trouble for the Phillips Curve π% . . . . . . . . . . 4% . . . 2% . . PC 5% 7% u%

Trouble for the Phillips Curve π% LRPC . . . . . . . . . 4% . . . 2% . . 5% un% 7% u%

The Long-Run Phillips Curve π% LRPC un% u% Note: Natural rate of unemployment is held constant

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 

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 NRU. 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% . SRPC 5% 7% u%

The Short-Run Phillips Curve (SRPC) π% . . . . . . . . . . 4% . . . SRPC1 2% . SRPC 5% 7% u%

.: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC  (Disinflation) SRAS  = SRPC  SRAS SRPC PL π% LRPC LRAS . . SRAS1 SRPC1   . . P π   P1 π1 AD   Y YF GDPR un u u% Inflationary Expectations↓, Input Prices↓, Productivity↑, Business Taxes↓, and/or Deregulation .: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC  (Disinflation)

.: SRAS  .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC  (Stagflation) SRAS  = SRPC  SRAS1 SRPC1 π% PL LRAS LRPC SRAS SRPC . .   . . P1 π 1   P π AD   Y1 YF GDPR un u1 u% Inflationary Expectations↑, Input Prices↑, Productivity↓, Business Taxes↑, and/or Increased Regulation .: SRAS  .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC  (Stagflation)

Summary There is a short-run trade off between u% & π% the short-run Phillips Curve (SRPC) In the long-run, no trade-off exists between u% & π%. Long-run Phillips Curve (LRPC) 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 