AP Macroeconomics The Phillips Curve

Homework Please read your notes and pages 724-728 in your textbook. Please answer question 4 on page 735 Graph the effects of each scenario on a properly labeled graph of AS/AD AND a graph of the Phillips Curve.

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

Increase in AD = Up/left movement along SRPC 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 in AD = Down/right 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

.: 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↓, Subsidies↑, 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↑, Subsidies↓, and/or Increased Regulation .: SRAS  .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC  (Stagflation)

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 key to understanding shifts in the Phillips curve is inverse relationships

Reconciling the LRPC and SRPC In the long-run, the inflation rate at B (π1 %) becomes the new expected inflation rate (π1%), and the economy returns to the natural rate of unemployment (point C). (All input costs have increased) SRAS moves left SRPC (π %) LRPC π % uN% A π% B C  π1 %  SRPC (π1 %) In the short-run, assuming the policy is successful, inflation occurs and unemployment decreases as the economy moves from A to B. u% u% Assume that either the government or the central bank enacts an expansionary policy to reduce the unemployment rate below its natural rate at point A. AD to the right

Reconciling the LRPC and SRPC In the long-run, the inflation rate at B (π1 %) becomes the new expected inflation rate (π1%), and the economy, once again, returns to the natural rate of unemployment (all input costs have decreased) (point C). SRPC (π %) LRPC π % uN% A π%  B C  π1 % SRPC (π1 %) In the short-run, assuming the policy is successful, disinflation occurs and unemployment increases as the economy moves from A to B. u% Now assume that either the government or the central bank enacts a contractionary policy to reduce inflation from its current rate at point A u%

Relating Phillips Curve to AS/AD Changes in the AS/AD model can 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.

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)

Summary (cont.) 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 Input Prices, Δ Productivity, Δ Business Taxes, Subsidies, and/or Δ Regulation = Δ SRAS = Δ SRPC SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC  SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC 