The Phillips Curve and Its Implications
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
.
•
1976 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
u
n
%
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
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
C
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.
C
π
1
%
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
Y
F
P
Y
AD
1
P
1
SRPC
π
u
π%
u%
u
n
π
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
Y
F
P
Y
AD
1
P
1
u%
π%
SRPC
u
n
π
u
π
1
.
.
.
.
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
Y
F
P
Y
SRAS
1
P
1
u%
π%
SRPC
LRPC
u
n
π
u
SRPC
1
π
1
.
.
.
.
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
Y
F
P
Y
1
SRAS
1
P
1
u%
π%
SRPC
LRPC
u
n
π
u
1
SRPC
1
π
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
Money Market
NIR
NIR
Q1
Q1
Q
Q
MD
MD
MS
MS
i
i
1
1
•
M
M
S
S
–
–
a
a
f
f
f
f
e
e
c
c
t
t
e
e
d
d
b
b
y
y
a
a
c
c
t
t
i
i
o
o
n
n
s
s
o
o
f
f
t
t
h
h
e
e
Federal Reserve
Federal Reserve
•
M
M
D
D
–
–
•
Transaction demand
Transaction demand
determined by GDP
determined by GDP
•
Asset demand
Asset demand
determined by NIR
determined by NIR
The Phillips Curve, introduced by economist A.W. Phillips in 1958, initially showed an inverse relationship between unemployment rate (u%) and inflation rate (tt%). This led policymakers to consider a trade-off between reducing unemployment and increasing inflation. However, the concept faced challenges during the 1970s with stagflation, leading to the development of the Long-Run Phillips Curve theory by Friedman and Phelps. The natural rate of unemployment plays a crucial role in these models, reflecting the equilibrium rate where real wages balance labor supply and demand. Structural changes in the economy can shift the Long-Run Phillips Curve, emphasizing the need for supply-side policies to address unemployment shifts.
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Presentation Transcript
AP Macro Phillips Curve, Monetary Policy
The Phillips Curve (hypothetical example) tt% . . . . 4% . . 2% . PC 5% 7% u% 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. 1976 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.
1970s Phillips Curve % . . . . . . . . .. . 4% . . . 2% . PC 5% 7% u%
The Long-Run Phillips Curve % LRPC un% u% 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 un, structural changes in the economy that affect un 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 un will shift LRPC Decreases in un will shift LRPC
LRPC Inflation rate 4% 2% SRPC (assumes 4 % expected inflation at each UR) SRPC (assumes 2% expected inflation at each UR) Natural rate of unemployment Unemployment rate Phillips Curve LR and SR
Summary There is a short-run trade off between u% & %. This is referred to as a short-run Phillips Curve (SRPC) In the long-run, no trade-off exists between u% & %. This is referred to as the long-run Phillips Curve (LRPC) The LRPC exists at the natural rate of unemployment (un). un .: LRPC un .: LRPC C, IG, G, and/or XN = AD = along SRPC AD .: GDPR & PL .: u% & % .: up/left along SRPC AD .: GDPR & PL .: u% & % .: down/right along SRPC Inflationary Expectations, Input Prices, Productivity, Business Taxes and/or Regulation = SRAS = SRPC SRAS .: GDPR & PL .: u% & % .: SRPC SRAS .: GDPR & PL .: u% & % .: SRPC
Reconciling the LRPC and SRPC In the long-run, the inflation rate at B ( 1%) becomes the new expected inflation rate ( 1^%), and the economy returns to the natural rate of unemployment (point C). LRPC tt% B C tt1% 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. A tt % In the short-run, assuming the policy is successful, inflation occurs and unemployment decreases as the economy moves from A to B. SRPC (tt1^ %) SRPC (tt^ %) u% uN% u%
Reconciling the LRPC and SRPC In the long-run, the inflation rate at B ( 1%) becomes the new expected inflation rate ( 1^%), and the economy, once again, returns to the natural rate of unemployment (point C). LRPC % A % 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 C B 1% SRPC ( ^ %) SRPC ( 1^ %) u% uN% u% 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.
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
Increase in AD = Up/left movement along SRPC % PL LRAS . . SRAS SRPC . . P1 1 P AD1 AD un u u% Y YF GDPR C , IG , G and/or XN .: AD .: GDPR & PL .: u% & % .: up/left along SRPC
Decrease in AD = Down/right along SRPC LRAS PL % . . SRAS SRPC . . P P1 1 AD AD1 YF Y GDPR u un u% C , IG , G and/or XN .: AD .: GDPR & PL .: u% & % .: down/right along SRPC
SRAS = SRPC SRAS SRPC PL % LRPC LRAS . . SRAS1 SRPC1 . . P 1 P1 AD un u u% Y YF GDPR Inflationary Expectations , Input Prices , Productivity , Business Taxes , and/or Deregulation .: SRAS .: GDPR & PL .: u% & % .: SRPC (Disinflation)
SRAS = SRPC SRAS1 SRPC1 % PL LRAS LRPC SRAS SRPC . . . . P1 1 P AD Y1 YF GDPR un u1 u% Inflationary Expectations , Input Prices , Productivity , Business Taxes , and/or Increased Regulation .: SRAS .: GDPR & PL .: u% & % .: SRPC (Stagflation)
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 un will shift LRPC Decreases in un will shift LRPC
MS NIR MS affected by actions of the Federal Reserve MD i1 Transaction demand determined by GDP Asset demand determined by NIR MD Q1 Q Money Market
