Phillips and Laffer Curves A.W. Phillips, 1958

Inflation-Unemployment Relationship Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment caused by changes in AD.Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment caused by changes in AD. AS shocks causeAS shocks cause higher rates of inflationhigher rates of inflation higher rates of unemployment.higher rates of unemployment. There is no significant trade-off over long periods of time.There is no significant trade-off over long periods of time.

Annual rate of inflation Unemployment rate (percent) As inflation declines... The Phillips Curve Concept Unemploymentincreases PC

The Phillips Curve Trade-Off UNEMPLOYMENT RATE INFLATION RATE REAL OUTPUT PRICE LEVEL √ Increases in AD causes movements along the Phillips Curve. √ As AD changes, the tradeoff between rate of inflation and rate of unemployment moves to a new position on PC. B C AD 1 AD 2 A AD 3 Phillips curve C B A AS PC

√ If Aggregate Demand moves upward, price level rises and Real GDP rises and is reflected as a new point on the short-run Phillips curve showing higher rate of inflation and lower unemployment. √ If AD moves down, price level falls and Real GDP falls and is reflected as a new point on the short- run Phillips curve showing lower rate of inflation and Higher unemployment. The Phillips Curve Trade-Off Short Run Summary

Phillips Curve in the 1960s

Phillips Curve Shifting in the 70s and 80s

Phillips “Curl” Unemployment got worse but so didinflation.

Adverse supply shocks can cause periods of rising unemployment and rising inflation. Rapid and significant increases in resource prices push Aggregate Supply to the left. Aggregate Supply and Shifting Views o PL 1 Y1Y1Y1Y1 AD 1 AS sr Price Level Real domestic output PL 2 Y2Y2Y2Y2 PL 3 Y3Y3Y3Y3 AS 2 sr AS 3 sr

√ The OPEC-induced price increases for oil in the 1970’s and the agricultural problems, depreciated dollar, a rise in wages following the wage-price control and declining productivity of mid 70’s announced STAGFLATION. √ In the later 80 and 90’s, the effect of high unemployment and hence smaller increases in wages were coupled with foreign competition that held down prices and wages. Deregulation and the decline of OPEC’s power pushed the rates back closer to the earlier tradeoff picture. The AS sr shifted back to its old position and the AS lr adjusted. Historical Evidence

Changes in AS move the Phillips Curve o PL 1 Y1Y1Y1Y1 AD 1 AS sr Price Level Real domestic output PL 2 Y2Y2Y2Y2 PL 3 Y3Y3Y3Y3 AS 2 sr AS 3 sr Annual rate of inflation Unemployment rate (percent) PC 1 PC 2 PC 3

15% SRPC3SRPC3SRPC3SRPC3 SRPC1SRPC1SRPC1SRPC1 SRPC2SRPC2SRPC2SRPC2 a1a1a1a1 a2a2a2a2 a3a3a3a3 b1b1b1b1 b2b2b2b2 b3b3b3b3 PC1 PC 2 PC 3 LRPC Inflat.GapRecess.Gap Inflation Rate Unemployment Rate 12% 9% 6% 3% 0 2%4%6%8%10% Phillips Curve Long Run AD changes move along the Philllips Curve AS changes move the Phillips Curve

1.Increases in AD beyond full employment temporarily boost profits, output and employment. (a 1 to b 1 ). 2.Nominal wages eventually catch up to sustain real wages; profit fall, canceling the short-run effect with employment returning to its full employment level.(b 1 to a 2 ), but at higher inflation. 3. The cycle starts again as AD grows, profits grow and employment rises (a 2 to b 2 ) 4. Again, in time, nominal wages catch up and employment returns to its natural rate. The reward is a higher inflation rate. Phillips Curve Long Run

√ The long-run Phillips curve is the vertical line through a 1, a 2, and a 3 at the natural rate of unemployment. √ Any rate of inflation is consistent with the 5% natural rate of unemployment. √ After all nominal wage adjustments to increases or decreases in inflation have occurred, the economy ends up back at full- employment natural rate position. The Phillips Curve —Long Run Summary

SUPPLY SIDE ECONOMICS AS is what determines inflation, growth and unemployment AS is what determines inflation, growth and unemployment High tax rates----hurt productivity, reduce savings/investment High tax rates----hurt productivity, reduce savings/investment –Also: discourage econ activity –Tax evasion Low tax rates (for businesses) encourage investment Low tax rates (for businesses) encourage investment –Encourage work, savings –Rewards for consumers who save decreases with higher marginal tax rates –Encourage people to enter labor force reducing unemployment –Increasing productivity –AS expands and keeps inflation low

0 100 l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent) Maximum Tax Revenue

CRITICISMS OF THE LAFFER CURVE Economic incentives don’t have as large an impact Economic incentives don’t have as large an impact Demand-side effects of a tax cut exceeds the supply-side effects Demand-side effects of a tax cut exceeds the supply-side effects 1980—Reganominces supported Laffer 1980—Reganominces supported Laffer –Tax decreased from 50-28% and productivity increased