1. Unit 3: Aggregate Demand and Supply and Fiscal Policy1

2. Review Draw an Inflationary Gap with your fingers.
Draw a Recessionary Gap with your fingers.
What is the self-correcting mechanism that will bring an inflationary gap back to equilibrium?
What is the self-correcting mechanism that will bring a recessionary gap back to equilibrium?
What does a negative supply shock do?
Name the factors that shift SRAS
Name Universities in Idaho.

3. 3.4 The Phillips Curve
Shows tradeoff between inflation and unemployment.
What happens to inflation and unemployment when AD increase?

4. In general, there is an inverse relationship between unemployment and inflation4

5. Unemployment and Inflation in the US 1955-1968

6. Short Run Phillips Curve
When the economy is overheating, there is low unemployment but high inflation
Inflation
When there is a recession, unemployment is high but inflation is low 5%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1%
SRPC 2% 9%
Unemployment 6

7. Short Run Phillips Curve
What happens when AS falls causing stagflation?
Increase in unemployment and inflation
Inflation 5%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC1 1%
SRPC 2% 9%
Unemployment 7

8. Short Run vs. Long Run Long Run Phillips Curve
In the long run there is no tradeoff between inflation and unemployment
Long Run Phillips Curve
Inflation 5%
The LRPC is vertical at the Natural Rate of Unemployment 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9%
Unemployment 8

9. The Phillips Curve in real life isn’t like the textbook

10. Draw the short-run Phillips curve and the long-run Phillips curve
Draw the short-run Phillips curve and the long-run Phillips curve. Explain why they are different

11. In the short run, monetary policy can affect the unemployment rate
an increase in the growth rate of money raises actual inflation above expected inflation, causing firms to produce more since the SRAS is positively sloped
In the long run monetary policy has no effect on unemployment, which tends toward its natural rate

12. AD/AS and the Phillips Curve

13. THE PHILLIPS CURVE
The Phillips curve shows the short-run trade-off between inflation and unemployment.

14. How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price
Inflation
Level
Short-run
aggregate
supply
High
aggregate demand
Rate
(percent
Phillips curve
per year)
Low aggregate
demand
(output is
8,000) B 4 6
8,000
(unemployment
is 4%)
106 B
(unemployment
is 7%)
7,500
102 A
(output is
7,500) A 7 2
Quantity
Unemployment
of Output
Rate (percent)

15. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS
The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

16. The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

17. Increasing the money supply will shift AD—raising prices and lowering unemployment

18. The Long-Run Phillips Curve
Inflation
Rate
Long-run
Phillips curve B
High
inflation
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
but unemployment
remains at its natural rate
in the long run.
Low
inflation A
Natural rate of
Unemployment
unemployment
Rate

19. The Meaning of “Natural”
The “natural” rate of unemployment is the rate to which the economy gravitates in the long run.
The natural rate is not necessarily desirable, nor is it constant over time.
Monetary policy cannot change the natural rate, but other government policies that strengthen labor markets can.

20. How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price
Long-run aggregate
Inflation
Long-run Phillips
Level
Rate
supply
curve
1. An increase in
the money supply
increases aggregate
demand . . .
and
increases the
inflation rate . . .
AD2 P2 B B
raises
the price
level . . . A P A
Aggregate
demand, AD
Natural rate
Quantity
Natural rate of
Unemployment
of output
of Output
unemployment
Rate
but leaves output and unemployment
at their natural rates.

21. The Short-Run Phillips Curve
Expected inflation measures how much people expect the overall price level to change
If employees think there will be high inflation, they will ask for a higher wage in their employment contract
If employers think there will be high inflation they will be willing to pay a higher wage, because it will still be cheaper than having to hire someone later
In the long run, expected inflation adjusts to changes in actual inflation.

22. How Expected Inflation Shifts the Short-Run Phillips Curve
but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Inflation
Rate
Long-run
Short-run Phillips curve
with high expected
inflation
Phillips curve C
Short-run Phillips curve
with low expected
inflation B
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . . A
Natural rate of
Unemployment
unemployment
Rate

23. The Natural Experiment for the Natural-Rate Hypothesis
The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.
Historical observations support the natural-rate hypothesis.
The concept of a stable Phillips curve broke down in the in the early ’70s.
During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

24. The Breakdown of the Phillips Curve in the 1970s
Inflation Rate
(percent per year) 10 8 6
1973
1970
1971
1969 4
1968
1972
1966
1967 2
1965
1962
1964
1961
1963 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)

25. AD/AS and the Phillips Curve
Show what happens on both graphs if AD increase
LRPC
Price Level
LRAS
Inflation AS
PLe
AD1 AD
SRPC QY
GDPR UY
Unemployment 25

26. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls?
Price Level
LRAS
LRPC
Inflation AS
PLe AD
SRPC
AD1 QY
GDPR UY
Unemployment 26

27. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC at full employment. What happens when AS falls?
Price Level
LRAS
LRPC
Inflation
AS1 AS
PLe
SRPC1 AD
SRPC QY
GDPR UY
Unemployment 27

28. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up?
Price Level
LRAS
LRPC
Inflation AS
AS1
PLe
SRPC AD
SRPC1 QY
GDPR UY
Unemployment 28

29. Draw three AD & AS curves and three short-run and long-run Phillips Curves
SRAS
LRPC
LRAS
Price Level
Inflation
SRPC QY
GDPR UY
Unemployment 29

30. SRAS LRPC LRAS Price Level Inflation PLe AD2 AD SRPC AD3 QY GDPR UY
Unemployment 30

31. AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPCQY
GDPR UY
Unemployment 31

32. AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPRUY
Unemployment 32

33. Analyzing the Economy Graphically33

34. PPC Business Cycle AD/AS Phillips Curve
Use the following models to show full employment, a recessionary gap, and an inflationary gap.
PPC
Business Cycle
AD/AS
Phillips Curve

35. The Good, the Bad, and the Ugly
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less 35