AP Macro Phillips Curve, Monetary Policy

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

The Phillips Curve In a 1958 paper, New Zealand born economist, A.W. Phillips published the results of his research on the historical relationship between the unemployment rate (u%) and the rate of inflation (tt%) in Great Britain. His research indicated a stable inverse relationship between the u% and the tt%. As u%↓, tt%↑ ; and as u%↑, tt%↓. The implication of this relationship was that policy makers could exploit the trade-off and reduce u% at the cost of increased tt%.

Trouble for the Phillips Curve In the 1970’s the U.S. experienced concurrent high u% & tt%, = stagflation American Nobel Prize economist Milton Friedman saw stagflation as disproof of the stable PC. Instead of a trade-off between u% & tt%, Friedman and 2006 Nobel Prize recipient Edmund Phelps believed that Un was independent of the tt%. This independent relationship is now referred to as the Long-Run Phillips Curve.

1970’s Phillips Curve π% u% PC 4% 2% 7%5%

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

Un defined The natural rate of unemployment (NRU) is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level It is where the aggregate supply of labor is in balance with the aggregate demand for labor. At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and there is no involuntary unemployment There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions.

The Long-Run Phillips Curve (LRPC) b/c the LRPC exists at the u n, structural changes in the economy that affect u n will also cause the LRPC to shift. In order to reduce the Un, structural policies must be directed towards an economy's supply side. Increases in u n will shift LRPC  Decreases in u n will shift LRPC 

Phillips Curve – LR and SR Inflation rate LRPC Unemployment rate SRPC (assumes 4 % expected inflation at each UR) Natural rate of unemployment 2% 4% SRPC (assumes 2% expected inflation at each UR)

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) The LRPC exists at the natural rate of unemployment (u n ). – u n ↑.: LRPC  – u n ↓.: LRPC  ΔC, ΔI G, ΔG, and/or ΔX N = Δ AD = Δ along SRPC – AD .: GDP R ↑ & PL↑.: u%↓ & π%↑.: up/left along SRPC – AD .: GDP R ↓ & 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 .: GDP R ↑ & PL↓.: u%↓ & π%↓.: SRPC  – SRAS .: GDP R ↓ & PL ↑.: u%↑ & π%↑.: SRPC 

SRPC ( tt^ %) LRPC tt % uN%uN% A BC tt 1 % u%   SRPC ( tt 1 ^ %) In the long-run, the inflation rate at B (π 1 % ) becomes the new expected inflation rate (π 1 ^ %), and the economy returns to the natural rate of unemployment (point C). Reconciling the LRPC and SRPC tt% 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. In the short-run, assuming the policy is successful, inflation occurs and unemployment decreases as the economy moves from A to B.

SRPC ( π^ %) LRPC π % uN%uN% A BC π1 %π1 % u%   SRPC ( π 1 ^ %) In the long-run, the inflation rate at B (π 1 % ) becomes the new expected inflation rate (π 1 ^ %), and the economy, once again, returns to the natural rate of unemployment (point C). Reconciling the LRPC and SRPC π% u% Now assume that either the government or the central bank enacts a Contractionary policy to reduce inflation from it’s current rate at point A In the short-run, assuming the policy is successful, disinflation occurs and unemployment increases as the economy moves from A to B.

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

Movements along the SRPC

Shifts of the SRPC Expected TT: If TT goes up – shift up. If TT goes down – shift down SRAS increases = shift SRPC right SRAS decreases = shift SRPC left

Shifts of the LRPC

Increase in AD = Up/left movement along SRPC C↑, I G ↑, G↑ and/or X N ↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π%↑.: up/left along SRPC GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    SRPC π u π% u%unun π 1π 1   ....

Decrease in AD = Down/right along SRPC C↓, I G ↓, G↓ and/or X N ↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓.: down/right along SRPC GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    u% π% SRPC unun π u π1π1   ....

SRAS  = SRPC  Inflationary Expectations↓, Input Prices↓, Productivity↑, Business Taxes↓, and/or Deregulation.: SRAS .: GDP R ↑ & PL↓.: u%↓ & π%↓.: SRPC  (Disinflation) GDP R PL AD SRAS LRAS YFYF P Y SRAS 1 P1P1    u% π% SRPC LRPC unun π u SRPC 1 π1π1   ....

SRAS  = SRPC  Inflationary Expectations↑, Input Prices↑, Productivity↓, Business Taxes↑, and/or Increased Regulation.: SRAS .: GDP R ↓ & PL↑.: u%↑ & π%↑.: SRPC  (Stagflation) GDP R PL AD SRAS LRAS YFYF P Y1Y1 SRAS 1 P1P1    u% π% SRPC LRPC unun π u1u1 SRPC 1    π 1π 1....

Phillips Curve Review SRAS increases = shift SRPC right SRAS decreases = shift SRPC left AD increases = movement up and left AD decreases = movement down and right Increases in u n will shift LRPC  Decreases in u n will shift LRPC 

Money Market NIR Q1 Q MD MS i1i1i1i1 MS – affected by actions of theMS – affected by actions of the Federal Reserve Federal Reserve MD –MD – Transaction demandTransaction demand determined by GDP determined by GDP Asset demandAsset demand determined by NIR determined by NIR