1. © 2007 Thomson South-Western Phillips Curve

2. © 2007 Thomson South-Western The Phillips Curve Phillips Curve (PC)– relationship between Inflation and Unemployment Short Run Phillips Curve

3. © 2007 Thomson South-Western The Phillips Curve  Deflation + extremely high UE rates = PC below the x axis (negative)

4. © 2007 Thomson South-Western The Phillips Curve CH Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B 6 7 A 2 Copyright © 2004 South-Western

5. © 2007 Thomson South-Western Long Run Phillips Curve (LRPC) LRPC is at the Natural Rate of Unemployment

6. © 2007 Thomson South-Western The Long-Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve B High inflation Low inflation A 2.... but unemployment remains at its natural rate in the long run. 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases... Copyright © 2004 South-Western

7. © 2007 Thomson South-Western How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level P Aggregate demand,AD Long-run aggregate supply Long-run Phillips curve (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve 2.... raises the price level... 1. An increase in the money supply increases aggregate demand... A AD 2 B A 4.... but leaves output and unemployment at their natural rates. 3.... and increases the inflation rate... P2P2 B Copyright © 2004 South-Western

8. © 2007 Thomson South-Western Expectations Expected inflation measures how much people expect the overall price level to change.

9. © 2007 Thomson South-Western How Expected Inflation Shifts the Short-Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short-run Phillips curve... 2.... but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B A Copyright © 2004 South-Western

10. © 2007 Thomson South-Western Supply Shocks and the PC A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. This shifts the economy’s aggregate supply curve...... and as a result, the Phillips curve.

11. © 2007 Thomson South-Western An Adverse Shock to Aggregate Supply Quantity of Output 0 Price Level Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve 3.... and raises the price level... AS 2 Aggregate supply,AS A 1. An adverse shift in aggregate supply... 4.... giving policymakers a less favorable tradeoff between unemployment and inflation. B P2P2 Y2Y2 P A Y Phillips curve,PC 2.... lowers output... PC 2 B Copyright © 2004 South-Western