Phillips Curve

Phillips Curve Short and Long Run Phillips Curves William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined

Phillips Curve Short and Long Run Phillips Curves In the years following Phillips' 1958 paper, many economists in the advanced industrial countries believed that his results showed that there was a permanently stable relationship between inflation and unemployment. One implication of this for government policy was that governments could control unemployment and inflation with a Keynesian policy. They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

Phillips Curve Inflation PL* Unemployment Quantity of Real GDP Price When the Economy is at Full Employment (“F-E RGDP”) Aggregate Demand (AD), Short Run Aggregate Supply (SRAS)and Long Run Aggregate Supply (LRAS) all intersect at the same point “A” Actual RGDP = Potential RGDP (F-E RGDP) Actual Unemployment Rate = The Natural Rate of Unemployment (NRU) or the Non-Accelerating Inflation Rate of Unemployment (NAIRU) We assume Price Stability at “PL*” Any deviation from Point “A” is going to create a different relationship between Inflation and Unemployment. Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS “A” PL* AD Fe RGDP Unemployment Quantity of Real GDP

Phillips Curve Inflation I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation If we take this Inflation Rate and Unemployment Rate and plot it on our Phillips Curve Graph, we have Our first point on our Phillips Curve—Point “A” LRAS SRAS “A” “A” I* PL* AD UR* (NRU) Fe RGDP Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS Assume AD INCREASES and shifts To the RIGHT. The new equilibrium is Point “B” at “PL1” and “RGDP 1”. Inflation has INCREASED (“Demand-Pull”) RGDP has INCREASED Unemployment has DECREASED “B” PL 1 “A” “A” AD 1 I* PL* AD UR 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I 1 PL 1 I* PL* Unemployment Aggregate Demand/Aggregate Supply Price Level If we plot this new relationship Between Inflation and Unemployment, We are now at Point “B” on the Phillips Curve HIGHER and to the LEFT of “A” Inflation increased from “I* to I1” and Unemployment Decreased from “UR* to UR1” Inflation LRAS SRAS “B” “B” I 1 PL 1 “A” “A” AD 1 I* PL* AD UR 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I 1 PL 1 I* PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS Notice the INVERSE relationship between Inflation and Unemployment that occurred as AD shifted to the RIGHT. “B” “B” I 1 PL 1 “A” “A” AD 1 I* PL* AD UR 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* PL 2 Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS Lets keep Point “B” on the Phillips Curve and start over on the AD/AS graph and see what happens If AD DECREASES. “B” PL 1 “A” “A” I* PL* PL 2 AD UR 1 UR* (NRU) Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* PL 2 Unemployment Aggregate Demand/Aggregate Supply AD DECREASES and shifts to the LEFT. New equilibrium at Point “C” with A lower level of Inflation “PL2” and a higher level of Unemployment that Accompanies a lower level or RGDP (“RGDP2”) Price Level Inflation LRAS SRAS “B” PL 1 “A” “A” I* PL* “C” PL 2 AD AD 2 UR* (NRU) Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* I 2 PL 2 Unemployment Aggregate Demand/Aggregate Supply If we plot this point on our Phillips Curve we can establish Point “C”, that illustrates Inflation DECREASING from “I* to I2” and Unemployment INCREASING from UR* To “UR2”. It is down and to the right of “A” Price Level Inflation LRAS SRAS “B” PL 1 “A” “A” I* PL* “C” “C” I 2 PL 2 AD AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* I 2 PL 2 Unemployment Aggregate Demand/Aggregate Supply Price Level Once again, note the INVERSE Relationship between Inflation And Unemployment that occurred as AD DECREASED and shifted to the LEFT Inflation LRAS SRAS “B” PL 1 “A” “A” I* PL* “C” “C” I 2 PL 2 AD AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 Unemployment Quantity of Real GDP

Phillips Curve Inflation I 1 PL 1 I* PL* I 2 PL 2 Unemployment Aggregate Demand/Aggregate Supply Price Level Lets re-insert the AD shifts on the Graphs to the right. We have established 3 core points on our Phillips Curve Graph which we Derived from the AD shifts- either to the left or to the right ALONG our FIXED SRAS curve. Each shift, RELATIVE to the starting point At Full-Employment, represents a change in the Relationship between Inflation and Unemployment Inflation LRAS SRAS “B” “B” I 1 PL 1 “A” “A” AD 1 I* PL* “C” “C” I 2 PL 2 AD AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I 1 PL 1 I* PL* I 2 PL 2 Unemployment Aggregate Demand/Aggregate Supply Price Level To finish out our Phillips Curve we need to look at the 2 extremes and see what happens to the relationship between Inflation and Unemployment if AD 1 curve kept increasing and shifting to the RIGHT or AD 2 is kept decreasing and shifting to the LEFT Inflation LRAS SRAS “B” “B” I 1 PL 1 “A” “A” AD 1 I* PL* “C” “C” I 2 PL 2 AD AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I 1 PL 1 I* PL* I 2 PL 2 Unemployment If AD 1 Curve continued to shift to the RIGHT we would produce no more RGDP, hence the Unemployment Rate would not drop any further. We would have no decrease in unemployment, but we would have increasing Inflation. This is represented by the VERTICAL section of the Phillips Curve Phillips Curve Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS “B” “B” I 1 PL 1 “A” “A” AD 1 I* PL* “C” “C” I 2 PL 2 AD AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL 1 PL* PL 2 Unemployment If AD 2 Curve continued to shift to the LEFT we would continue to have a decrease in RGDP and an increase in Unemployment BUT the Inflation would eventually level out because “stuff “would never be produced below certain prices. We would have a continued decrease in unemployment, but we would have a bottoming out of Inflation This is represented by the HORIZONTAL section of the Phillips Curve Phillips Curve Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS “B” “B” PL 1 “A” “A” AD 1 PL* “C” “C” PL 2 AD SRPC* AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation “Short Run Phillips Curve” PL 1 PL* Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS Connect the dots and we have a “SHORT RUN PHILLIPS CURVE” “Short Run Phillips Curve” “B” “B” PL 1 “A” “A” AD 1 PL* “C” “C” PL 2 AD SRPC* AD 2 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 2 RGDP 1 Unemployment Quantity of Real GDP

Short Run Phillips Curve Represents the trade-off between Inflation and Unemployment as AD increases or decreases ALONG the Fixed Short Run Aggregate Supply Curve

Short Run Aggregate Supply Shocks! What SHIFTS the Short Run Phillips Curve (SRPC) to the Left or to the Right? Short Run Aggregate Supply Shocks! A NEGATIVE SUPPLY shock (SRAS shifts to the LEFT) will shift the SRPC to the RIGHT! A POSITIVE SUPPLY shock (SRAS shifts to the RIGHT) will shift the SRPC to the LEFT

SRPC* Phillips Curve Inflation PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS Let start over to illustrate how a Shift in the SRAS curve will cause a Shift of the Phillips Curve. For simplicity I will take out the LRAS, but Understand it still exits. “B” “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation SRAS “B” “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL 1 PL* Unemployment Aggregate Demand/Aggregate Supply Assume a Negative Supply Shock SRAS curve shifts to the LEFT and we establish a new equilibrium a At Point “B”—”COST PUSH INFLATION” Price Level INCREASES RGDP DECREASES Unemployment INCREASES Opps!---this does not conform to our nice and neat INVERSE relationship between Inflation and Unemployment. It appears now to be a DIRECT relationship Price Level Inflation SRAS 1 SRAS “B” “B” PL 1 “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL 1 PL* Unemployment Aggregate Demand/Aggregate Supply Notice Point “B” on AD/AS is at a HIGHER Level of Inflation AND a HIGHER level Of Unemployment RELATIVE to Point “A”. If we plot this point on the Phillips Curve Graph We will find that point is ABOVE and to the LEFT of “A” Price Level Inflation SRAS 1 SRAS “B” “B” “B” PL 1 “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL 1 PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation SRAS 1 SRAS We have established ONE Inflation/Unemployment Point that now lies to the RIGHT of the SRPC*. “B” “B” “B” PL 1 “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL 1 PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation If policies were implemented to shift AD either to the LEFT or RIGHT we would create a NEW Phillips Curve that lies to the RIGHT of the previous one (SRPC*) SRAS 1 SRAS “B” “B” “B” PL 1 “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC 1 SRPC* Phillips Curve Inflation PL 1 PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation SRAS 1 SRAS Helpful Hint: If SRAS curve shifts to the LEFT Then the Phillips Curve will shift to the RIGHT “B” “B” “B” PL 1 “A” “A” PL* SRPC 1 “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC 1 SRPC* Phillips Curve Inflation PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation SRAS 1 SRAS How it looks cleaned up!! PL* SRPC 1 AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation SRAS What happens to the Phillips Curve If there is a POSTIVE Supply Shock? “B” “A” “A” PL* “C” AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL* PL 1 Unemployment Aggregate Demand/Aggregate Supply Assume a Positive Supply Shock SRAS curve shifts to the RIGHT and we establish a new equilibrium a At Point “B” Price Level DECREASES RGDP INCREASES Unemployment DECREASES Opps!---this does not conform to our nice and neat INVERSE relationship between Inflation and Unemployment. It appears now to be a DIRECT relationship Price Level Inflation SRAS SRAS 1 “B” “A” “A” PL* “B” “C” PL 1 AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL* PL 1 Unemployment Aggregate Demand/Aggregate Supply Notice Point “B” on AD/AS is at a LOWER Level of Inflation AND a LOWER level of Unemployment RELATIVE to Point “A”. If we plot this point on the Phillips Curve Graph we will find that point is BELOW and to the LEFT of “A” Price Level Inflation SRAS SRAS 1 “B” “A” “A” PL* “B” “B” “C” PL 1 AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* Phillips Curve Inflation PL* PL 1 Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation SRAS SRAS 1 We have established ONE Inflation/Unemployment Point that now lies to the LEFT of the SRPC*. “B” “A” “A” PL* “B” “B” “C” PL 1 AD SRPC* UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* SRPC 1 Phillips Curve Inflation PL* PL 1 Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation If policies were implemented to shift AD either to the LEFT or RIGHT we would create a NEW Phillips Curve that lies to the LEFT of the previous one (SRPC*) SRAS SRAS 1 “B” “A” “A” PL* “B” “B” “C” PL 1 AD SRPC* SRPC 1 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* SRPC 1 Phillips Curve Inflation PL* PL 1 Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation SRAS SRAS 1 Helpful Hint: If SRAS curve shifts to the RIGHT Then the Phillips Curve will shift to the LEFT “B” “A” “A” PL* “B” “B” “C” PL 1 AD SRPC* SRPC 1 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

SRPC* SRPC 1 Phillips Curve Inflation Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation SRAS SRAS 1 Here is how it looks cleaned up! AD SRPC* SRPC 1 UR 1 UR* (NRU) UR 2 Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Long Run Phillips Curve Easy, Cheesey!! In the long run, there is no trade off between Inflation and Unemployment

Phillips Curve Inflation I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS We will start out at our neutral position. The NRU and Price Stability---the “NAIRU” “A” “A” I* PL* AD* UR* (NRU) Fe RGDP Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS Assume AD increases and shifts to the RIGHT. Price Level INCREASES RGDP INCREASES Unemployment DECREASES Our new equilibrium is at Point “B” (note this!) Absent any policy interventions we will see how the “Self-Correcting Mechanism” will work to get the economy back to full-employment “B” PL 1 “A” “A” AD 1 I* PL* AD* UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS We already know that this movement along the SRAS Curve IN THE SHORT RUN and will create movement ALONG a Short Run Phillips Curve (Up and to the Left). However, now we want to transition to the LONG RUN situation. “B” PL 1 “A” “A” AD 1 I* PL* AD* UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 1 I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply The economy is experiencing INFLATION AND the Actual Unemployment Rate is now BELOW the NRU. This going to create conditions for “Wage Inflation” Remember: Wages are an input into the Cost of Producing When input prices INCREASE what happens to SRAS? Price Level Inflation LRAS SRAS “B” PL 1 “A” “A” AD 1 I* PL* AD* UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL 2 PL 1 I* PL* Unemployment Aggregate Demand/Aggregate Supply A NEGATIVE SUPPLY SHOCK. SRAS shifts to the LEFT Price Level INCREASES RGDP DECREASES Unemployment DECREASES New Equilibrium after the LONG TERM ADJUSTMENT is at Point “C” NOTE:We have returned to Full-employment RGDP and the NRU BUT at a HIGHER Price Level than before Price Level Inflation LRAS SRAS 1 SRAS “C” PL 2 “B” PL 1 “A” “A” AD 1 I* PL* AD* UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I1 PL 2 PL 1 I* PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS 1 SRAS Plot Point “C” from AD/AS on the Phillips Curve “C” “C” I1 PL 2 “B” PL 1 “A” “A” AD 1 I* PL* AD* UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I1 PL 2 PL 1 I* PL* Unemployment Aggregate Demand/Aggregate Supply Price Level Point “C” represents below Represents a HIGHER Price Level back at the NRU Inflation LRAS SRAS 1 SRAS “C” “C” I1 PL 2 “B” PL 1 “A” “A” AD 1 I* PL* AD* UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Now, Let’s look at it from the perspective of a DECREASE in AD

Phillips Curve Inflation I1 I* PL* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS We will start out at our neutral position. The NRU and Price Stability---the “NAIRU” “C” I1 “A” “A” I* PL* AD* UR* (NRU) Fe RGDP Unemployment Quantity of Real GDP

Phillips Curve Inflation I* PL* PL 1 Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation Assume AD decreases and shifts to the LEFT. Price Level DECREASES RGDP DECCREASES Unemployment INCREASES Our new equilibrium is at Point “B” (note this!) Absent any policy interventions we will see how the “Self-Correcting Mechanism” will work to get the economy back to full-employment LRAS SRAS “C” “A” “A” I* PL* “B” PL 1 AD* AD 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP PL 2

Phillips Curve Inflation I* PL* PL 1 Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation The economy is experiencing RECESSION AND the Actual Unemployment Rate is now ABOVE the NRU. This going to create conditions for “Wage Deflation” Remember: Wages are an input into the Cost of Producing When input prices DECREASE what happens to SRAS? LRAS SRAS “C” “A” “A” I* PL* “B” PL 1 AD* AD 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP PL 2

Phillips Curve Inflation I1 I* PL* PL 1 PL 2 Unemployment Aggregate Demand/Aggregate Supply A POSITIVE SUPPLY SHOCK. SRAS shifts to the RIGHT Price Level DECREASES RGDP INCREASES Unemployment DECREASES New Equilibrium after the LONG TERM ADJUSTMENT is at Point “C” NOTE:We have returned to Full-employment RGDP and the NRU BUT at a LOWER Price Level than before Price Level Inflation LRAS SRAS 1 SRAS “C” I1 “A” “A” I* PL* “B” PL 1 AD* PL 2 “C” AD 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation I* PL* PL 1 I2 PL 2 Unemployment Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS 1 SRAS Plot Point “C” from AD/AS on the Phillips Curve “A” “A” I* PL* “B” PL 1 I2 AD* “C” PL 2 “C” AD 1 UR* (NRU) Fe RGDP RGDP 1 Unemployment Quantity of Real GDP

Phillips Curve Inflation PL* I* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS LRAS* If we connect our points on the PHILLIP CURVE We will derive the LONG RUN PHILLIPS CURVE “A” “A” PL* I* AD* UR* (NRU) Fe RGDP Unemployment Quantity of Real GDP

Phillips Curve Inflation PL* I* Unemployment Quantity of Real GDP Aggregate Demand/Aggregate Supply Price Level Inflation LRAS SRAS LRAS* The Long Run Phillips Curve suggests There is ON Long Term Trade-off between Inflation and Unemployment “A” “A” PL* I* AD* UR* (NRU) Fe RGDP Unemployment Quantity of Real GDP

What can shift the LONG RUN PHILLIPS CURVE? Anything that might change the Natural Rate of Unemployment Remember: The NRU is comprised of a. Frictional Unemployment b. Structural Unemployment Policies that INCREASE these types of unemployment will INCREASE the NRU and the LONG RUN PHILLIPS CURVE will shift to the RIGHT. Policies that DECREASE these types of unemployment will DECREASE the NRU and the LONG RUN PHILLIPS CURVE will shift to the LEFT A change is government benefits for the unemployed—incentives or dis-incentives to work 2. A change in education/skill level of the population 3. An increase in Labor and Capital (Technology) Productivity

Phillips Curve and The short and long terms effects of inflaton. We will use as an example a sub-topic from the #1 FRQ from the 2009 AP Macroeconomics Test

They decide to target 3% as a “preferred” level of Inflation. LRAS Price Level SRAS LRPC INFLATION PL* AD* 6% RGDP* RGDP SRPC NRU UNEMPLOYMENT The INFLATION RATE currently is 6% and the Federal Reserve believes that is too HIGH. They decide to target 3% as a “preferred” level of Inflation.

INCREASE the FEDERAL FUNDS RATE and tend to INCREASE INTEREST RATES Price Level SRAS LRPC INFLATION PL* AD* 6% RGDP* RGDP SRPC NRU UNEMPLOYMENT In order to DECREASE INFLATION the Federal Reserve would carry out the Open Market Operation or SELLING BONDS---this will DECREASE the Money Supply and INCREASE the FEDERAL FUNDS RATE and tend to INCREASE INTEREST RATES throughout the Financial System.

INCREASING INTEREST RATES will cause AD to DECREASE Price Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP SRPC NRU UNEMPLOYMENT INCREASING INTEREST RATES will cause AD to DECREASE

REAL GDP will DECREASE AND PRICE LEVEL (inflation) will DECREASE AND SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP SRPC NRU UNEMPLOYMENT REAL GDP will DECREASE AND PRICE LEVEL (inflation) will DECREASE AND Because RGDP DECREASES, UNEMPLOYMENT will INCREASE

INFLATION is DECREASING and UMEPLOYMENT IS INCREASING---There is Price Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP 3% SRPC NRU UR1 UNEMPLOYMENT INFLATION is DECREASING and UMEPLOYMENT IS INCREASING---There is MOVEMENT ALONG THE PHILLIPS CURVE IN THE SHORT RUN

The Economy settles at a LOWER INFLATION RATE and a HIGHER Price Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP 3% SRPC NRU UR1 UNEMPLOYMENT The Economy settles at a LOWER INFLATION RATE and a HIGHER UNEMPLOYMENT RATE…

NOTE: This is the situation in the “SHORT-RUN”---What is the LONG-TERM Price Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP 3% SRPC NRU UR1 UNEMPLOYMENT NOTE: This is the situation in the “SHORT-RUN”---What is the LONG-TERM EFFECT of the Federal Reserves action?

Be “built-in”---They have expectations of LOWER PRICES AND WAGES…. Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP 3% SRPC NRU UR1 UNEMPLOYMENT People (and business and govt) EXPECTIONS about INFLATION are now going to Be “built-in”---They have expectations of LOWER PRICES AND WAGES….

This will affect a number of things BUT lets focus on WAGES Price Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP 3% SRPC NRU UR1 UNEMPLOYMENT This will affect a number of things BUT lets focus on WAGES

Because there are expectations of LOWER Inflation then WAGES tend to Price Level SRAS LRPC INFLATION PL* PL1 AD* 6% AD1 RGDP1 RGDP* RGDP 3% SRPC NRU UR1 UNEMPLOYMENT Because there are expectations of LOWER Inflation then WAGES tend to Stabilize and MAY decrease (assume this to be the case)…On the AD/AS Graph, which curve is going to be affected???

Aggregate Supply!! Cost of Production will tend to DECREASE…When C.O.P SRAS Price Level SRAS1 LRPC INFLATION PL* PL1 AD* PL2 6% AD1 RGDP1 RGDP* RGDP2 RGDP 3% SRPC NRU UR1 UNEMPLOYMENT Aggregate Supply!! Cost of Production will tend to DECREASE…When C.O.P DECREASES then Aggregate Supply will INCREASE (Shift to the Right)

FE FGDP* therefore UNEMPLOYMENT has DECREASED. SRAS Price Level SRAS1 LRPC INFLATION PL* PL1 AD* PL2 6% AD1 RGDP1 RGDP* RGDP2 RGDP 3% SRPC NRU UR1 UNEMPLOYMENT Price Level (inflation) has DECREASED and RGDP has INCREASED (back to the original FE FGDP* therefore UNEMPLOYMENT has DECREASED.

UNEMPLOYMENT the PRICE LEVEL will be LOWER. SRAS Price Level SRAS1 LRPC INFLATION PL* PL1 AD* PL2 6% AD1 RGDP1 RGDP* RGDP2 RGDP 3% SRPC NRU UR1 UNEMPLOYMENT How does this affect the Phillips Curve??? When the SRAS curve shifts to the RIGHT The Short-Run Phillips Curve shifts to the LEFT!! Now at every level of UNEMPLOYMENT the PRICE LEVEL will be LOWER.

Equilibrium where SRPC intersect LRPC at the NRU….THE LONG RUN SRAS Price Level SRAS1 LRPC INFLATION PL* PL1 AD* PL2 6% AD1 RGDP1 RGDP* RGDP2 RGDP 3% Economy is BACK to FE where AD = SRAS=LRAS We are STILL at the NRU but at a LOWER I INFLATION RATE!! SRPC NRU UR1 UNEMPLOYMENT With the shift of The Short Run Phillips Curve we move back to Long-Run Equilibrium where SRPC intersect LRPC at the NRU….THE LONG RUN PHILLIPS CURVE IS NOT GOING TO SHIFT.

The End