1. ADAS and Phillips Curve

2. AD/SRAS overview Aggregate Demand Short Run Aggregate Supply
Total spending on goods and services in the economy.
A change in C, I, G, or Xn causes a change in AD
PL and output (y) are changed by a change in AD
Short Run Aggregate Supply
Total amount of goods and services produced in the economy.
A change in input prices, productivity and government policies change SRAS
PL and output(y) are changed when SRAS changes.

3. Economic Conditions AD/AS at Full Employment Price Level LRAS SRAS ADYF PL
AD/AS in Recession Y1
Price Level
LRAS
SRAS AD YF PL
GDPR
GDPR
Price Level
LRAS
SRAS AD YF PL
AD/AS with high inflation Y1
Price Level
LRAS
SRAS AD YF PL
AD/AS with Stagflation Y1
GDPR
GDPR

4. Changes in AD/SRAS… You tell me what changes and what happens to PL and output
The government spends money national defense
The price of oil rises
There is a fall in consumer confidence
Argentina buys more of US made goods
The government increases regulation
Interest rates increase
Wages decrease
Expansionary monetary policy
The government gives subsidies to businesses
↑ AD, ↑ PL, ↑Y
↓ SRAS, ↑ PL, ↓ Y
↓ AD, ↓ PL, ↓Y
↑ AD, ↑ PL, ↑Y
↓ SRAS, ↑ PL, ↓ Y
↓ AD, ↓ PL, ↓Y
↑ SRAS, ↓PL, ↑ Y
↑ Sm, ↑ irN , ↑ AD, ↑ PL, ↑Y
↑ SRAS, ↓PL, ↑ Y

5. EFFECTS OF AD CHANGES? Relationship
LRAS
LRAS PL PL
SRAS
SRAS
PL2
PL1
PL1
PL2
AD2
AD1
AD1
AD2 Y2 YF
GDPR
YF Y2
GDPR
 AD ____ PL ____ Unemployment
 AD ____ PL ____ Unemployment
Trade-off!
Relationship
Between PL and Unemployment:
(in the short run)
Click the mouse once to fill in the blanks.

6. The Short Run Phillips Curve
Key Idea:
In the short run there is a TRADE-OFF between INFLATION and UNEMPLOYMENT.
To reduce unemployment – inflation occurs
To reduce inflation --- unemployment increases
Research by a Kiwi (New Zealand) economist named Williams Phillips documented this relationship in 1958 by studying the UK from As a result a new model was developed to illustrate the trade-off:
The Short Run Phillips Curve

7. The Short Run Phillips Curve
Inflation
Rate
Inflation
Rate %1 %2 %2 %1
SRPC
SRPC
U U2
Unemployment
Rate
U U1
Unemployment
Rate
 Inflation rate   unemployment rate
 Inflation rate  ↓ unemployment rate
Due to the trade-off (inverse relationship), what is the shape of the SRPC?
Downward-sloping!

8. Goal
Address the problem without creating a worse problem – limit the negative effects.
When stagflation first occurred in the 1970s due to a supply-side shock (  price of oil/energy), it created a new dilemma for policymakers and called into question the credibility of the short run Phillips Curve (SRPC) relationship.

9. Stagflation:
????
LRAS PL
SRAS2
Does stagflation negate the SRPC trade-off between inflation and unemployment?
Some economists rejected the SRPC relationship; others found an alternative explanation.
SRAS1
PL2
PL1
It appears to negate the inverse
relationship. Both PL and
unemployment increase! AD Y2 YF
GDPR
 SRAS  ____ PL ____ Unemployment

10. Stagflation and the SRPC
Inflation
Rate
Inflation
Rate % %2
SRPC2
SRPC2 %1
SRPC1
SRPC1 U
Unemployment
Rate U1 U2
Unemployment
Rate
Explanation:
Stagflation simply caused the SRPC to shift to the right --- indicating that for
each level of unemployment, there is a higher rate of inflation; for each
inflation rate, there is a higher level of unemployment.

11. What about an increase in SRAS?
LRAS PL
Inflation
Rate
For each level of inflation,
a lower level of unemploy-
ment exists.
SRAS1
SRAS2
Shift Left %1 %2
PL1
PL2
SRPC1
SRPC2 AD U
Unemployment
Rate YF Y2
GDPR
For each level of unemployment,
a lower level of inflation exists.
 SRAS  ____ PL ____ Unemployment

12. Increase in AD → movement along Phillips Curve
Price Level
LRAS
SRAS AD YF PL
GDPR A
Inflation
Rate
Unemployment
LRPC
SRPC %A
NRU B %B
PL2
AD2

13. Shift in SRAS→ Shift in SRPC
Price Level
LRAS
SRAS AD YF PL
GDPR A
Inflation
Rate
Unemployment
LRPC
SRPC %A
NRU B %B
PL2
SRAS2
SRPC2

14. Practice Problems
A short Run Phillips Curve shows an inverse relationship between
Interest rates and borrowing
Inflation and unemployment
Income and consumption
Prices and quantity demanded
Inputs and outputs

15. Practice Problems Stagflation is most likely to be caused by
An increase in AD
A decrease in AD
An increase in AS
A decrease in AS
A large increase in the money supply

16. Practice Problems
An increase in personal income taxes will most likely cause AD and AS to change in which of the following ways in the short run? AD AS
Not change Decrease
Not change Increase
Decrease Not Change
Decrease Increase
Increase Not Change

17. Practice Problems
When firms restructure their operations to decrease production cost, the AS, PL and real output will change in which of the following ways?
AS PL Output
Shift left Increase Increase
Shift left Increase No Change
Shift right Increase Increase
Shift right Decrease Increase
Shift right Decrease Decrease

18. Practice Problems
When an economy is at full employment, which of the following will most likely create demand pull inflation in the short run?
Increase in the discount rate
An increase in personal income taxes
A decrease in the real rate of interest
A decrease in government spending
A decrease in the money supply

19. Practice Problems An increase in AD will cause which of the following?
A movement along a given SRPC
The LRPC to become horizontal
An increase in the natural rate of unemployment
A decrease in the capital stock
A decrease in the expected price level

20. Practice Problems
Which of the following would cause the SRAS to shift to the right?
An increase in the age rate
An increase in the interest rate
An increase in the natural rate of unemployment
A decrease in capital stock
A decrease in the expected price level

21. Assume that the United States economy is currently in a recession in a short-run equilibrium.
Draw a correctly labeled graph of the short-run and long-run Phillips curves. Use the letter A to label a point that could represent the current state of the economy in recession.
(b) Draw a correctly labeled graph of aggregate demand and aggregate supply in the recession and show each of the following.
The long-run equilibrium output, labeled Yf
The current equilibrium output and price levels, labeled Ye and PLe, respectively
To balance the federal budget, suppose that the government decides to raise income taxes while maintaining the current level of government spending. On the graph drawn in part (b), show the effect of the increase in taxes. Label the new equilibrium output and price levels Y2 and PL2, respectively.
Assume that the Federal Reserve uses monetary policy to stimulate the economy.
What open-market policy should the Federal Reserve implement?
Using a correctly labeled graph of the money market, show how the policy in part (d)(i) affects nominal interest rates.
What will be the impact of the policy on the price level? Explain.
Now assume instead that the government and the Federal Reserve take no policy action in response to the recession.
In the long run, will the short-run aggregate supply increase, decrease, or remain unchanged? Explain.
In the long run, what will happen to the natural rate of unemployment?

22. The unemployment rate in the country of Southland is greater than the natural rate of unemployment.
Using a correctly labeled graph of aggregate demand and aggregate supply, show the current equilibrium real gross domestic product, labeled YC, and price level in Southland, labeled PLC.
The president of Southland is receiving advice from two economic advisers—Kohelis and Raymond—about how best to reduce unemployment in Southland.
Kohelis advises the president to decrease personal income taxes.
How would such a decrease in taxes affect aggregate demand? Explain.
Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in taxes. Label the initial equilibrium from part (a) as point A, and the new equilibrium resulting from the decrease in taxes as point B.
Raymond advises the president to take no policy action.
What will happen to the short-run aggregate supply curve in the long run? Explain.
Using a new correctly labeled graph of the short-run Phillips curve, show the effect of the change in the short-run aggregate supply you identified in part (c)(i).

23. Assume that a country’s economy is in equilibrium.
Using a correctly labeled ADAS graph, show how an increase in the price of oil, an important resource will affect the price level and output in the short run.
Using a correctly labeled graph, who how the increase in the price of oil affects the short run phillips curve.
Assume that the central bank responds to the higher price of oil by increasing the money supply.
Explain the process by which the increase in the money supply will affect the AD in the short run.
Indicate how the increase in the money supply will affect real output and price level.
Now assume instead of using monetary policy in response to the oil price increase, the government reduces business taxes, which result in lower production cost. Using a new correctly labeled graph, who the effect of the reduction in business taxes on the PL and output in the short run.