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PHILLIPS CURVE
Phillips Curve
Short and Long Run Phillips Curves
• William Phillips, a New Zealand born economist,
wrote a paper in 1958 titled The Relation between
Unemployment and the Rate of Change of Money
Wage Rates in the United Kingdom, 1861-1957,
which was published in the quarterly journal
Economica.
• In the paper Phillips describes how he observed an
inverse relationship between money wage changes
and unemployment in the British economy over the
period examined
PHILLIPS CURVE
SHORT AND LONG RUN PHILLIPS CURVES
• In the years following Phillips' 1958 paper, many economists in
the advanced industrial countries believed that his results
showed that there was a permanently stable relationship
between inflation and unemployment.
• One implication of this for government policy was that
governments could control unemployment and inflation with a
Keynesian policy.
• They could tolerate a reasonably high rate of inflation as this
would lead to lower unemployment – there would be a tradeoff between inflation and unemployment.
• For example, monetary policy and/or fiscal policy (i.e., deficit
spending) could be used to stimulate the economy, raising
gross domestic product and lowering the unemployment rate.
Moving along the Phillips curve, this would lead to a higher
inflation rate, the cost of enjoying lower unemployment rates.
When the EconomyPhillips
is at Full Employment
Curve (“F-E
RGDP”) Aggregate Demand (AD), Short Run
Aggregate Supply (SRAS)and Long Run
Inflation
Aggregate Supply (LRAS) all intersect at the
same point “A”
1. Actual RGDP = Potential RGDP (F-E
RGDP)
2. Actual Unemployment Rate = The
Natural Rate of Unemployment (NRU)
or the Non-Accelerating Inflation Rate
of Unemployment (NAIRU)
3. We assume Price Stability at “PL*”
Aggregate Demand/Aggregate Supply
Price
Level
LRAS
SRAS
“A”
PL*
Any deviation from Point “A” is going to
create a different relationship between
Inflation and Unemployment.
AD
Fe
RGDP
Unemployment
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Price
If we take this Inflation Rate Level
and Unemployment
Rate and plot it on our Phillips Curve Graph, we have
Our first point on our Phillips Curve—Point “A”
SRAS
“A”
“A”
I*
LRAS
PL*
AD
UR*
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Assume AD INCREASES and shifts
To the RIGHT.
Aggregate Demand/Aggregate Supply
Price
Level
LRAS
SRAS
The new equilibrium is Point “B” at
“PL1” and “RGDP 1”.
Inflation has INCREASED (“Demand-Pull”)
RGDP has INCREASED
Unemployment has DECREASED
“A”
“A”
I*
“B”
PL 1
PL*
AD 1
AD
UR 1
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Price
If we plot this new relationship
Between Inflation and Unemployment, Level
We are now at Point “B” on the Phillips Curve
HIGHER and to the LEFT of “A”
LRAS
SRAS
Inflation increased from “I* to I1” and
Unemployment Decreased from “UR* to UR1”
I1
“B”
“B”
PL 1
“A”
“A”
I*
PL*
AD 1
AD
UR 1
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
Notice the INVERSE relationship between
Inflation and Unemployment that occurred as
AD shifted to the RIGHT.
I1
“B”
“B”
PL 1
“A”
“A”
I*
PL*
AD 1
AD
UR 1
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
Lets keep Point “B” on the
Phillips Curve and start over on
the AD/AS graph and see what
happens If AD DECREASES.
“B”
LRAS
PL 1
“A”
“A”
I*
SRAS
PL*
PL 2
UR 1
UR*
(NRU)
Unemployment
AD
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
AD DECREASES and shifts to the LEFT.
Price
New equilibrium at Point “C” with
A lower level of Inflation “PL2” and
a higher level of Unemployment that
Accompanies a lower level or RGDP
(“RGDP2”)
“B”
LRAS
Level
SRAS
PL 1
“A”
“A”
I*
PL*
“C”
PL 2
AD
AD 2
UR*
(NRU)
Unemployment
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
If we plot this point on our
Price
Phillips Curve we can establish Level
Point “C”, that illustrates Inflation
DECREASING from “I* to I2” and
Unemployment INCREASING from UR*
To “UR2”. It is down and to the right of “A”
“B”
LRAS
SRAS
PL 1
“A”
“A”
I*
PL*
“C”
I2
“C”
PL 2
AD
AD 2
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 2
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Once again, note the INVERSE Price
Relationship between Inflation Level
And Unemployment that occurred as
AD DECREASED and shifted to the LEFT
“B”
LRAS
SRAS
PL 1
“A”
“A”
I*
PL*
“C”
I2
“C”
PL 2
AD
AD 2
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 2
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Inflation We have established 3 core points on our PhillipsLevel
Curve Graph which
Lets re-insert the AD shifts on the Graphs to the right.
LRAS
SRAS
we Derived from the AD shifts- either to the left or to the right
ALONG our FIXED SRAS curve.
Each shift, RELATIVE to the starting point At Full-Employment,
represents a change in the Relationship between Inflation and
Unemployment
I1
“B”
“B”
PL 1
“A”
“A”
I*
PL*
“C”
I2
AD 1
“C”
PL 2
AD
AD 2
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Inflation
I1
Aggregate Demand/Aggregate Supply
To finish out our PhillipsPrice
Curve we need to
Level
look at the 2 extremes and
see what happens
to the relationship between Inflation and
Unemployment if AD 1 curve kept increasing
and shifting to the RIGHT or AD 2 is kept
decreasing and shifting to the LEFT
“B”
LRAS
“B”
PL 1
“A”
“A”
I*
PL*
“C”
I2
SRAS
AD 1
“C”
PL 2
AD
AD 2
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
If AD 1 Curve continued to shift to the RIGHT we would
produce no more RGDP, hence the Unemployment Rate
would not drop any further.
Aggregate Demand/Aggregate Supply
Phillips Curve
Pricein unemployment, but we
We would have no decrease
would have increasingLevel
Inflation.
Inflation
LRAS
SRAS
This is represented by the VERTICAL section of the Phillips
Curve
I1
“B”
“B”
PL 1
“A”
“A”
I*
PL*
“C”
I2
AD 1
“C”
PL 2
AD
AD 2
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
If AD 2 Curve continued to shift to the LEFT we would
continue to have a decrease in RGDP and an increase in
Unemployment BUT the Inflation would
eventually level
Aggregate
Demand/Aggregate Supply
out because “stuff “would never be produced below
Price
certain prices.
Phillips Curve
Inflation
LRAS
Level
SRAS
We would have a continued decrease in unemployment,
but we would have a bottoming out of Inflation
This is represented by the HORIZONTAL section of the
Phillips Curve
“B”
“B”
PL 1
“A”
“A”
PL*
“C”
“C”
PL 2
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
AD 1
AD 2
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
Connect the dots and we have a
“SHORT RUN PHILLIPS CURVE”
“Short Run
“B” Phillips Curve”
“B”
PL 1
“A”
“A”
PL*
“C”
“C”
PL 2
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
AD 1
AD 2
RGDP 2
Fe
RGDP
RGDP 1
Quantity of Real GDP
Short Run Phillips
Curve
Represents the trade-off between Inflation
and Unemployment as AD increases or
decreases ALONG the Fixed Short Run
Aggregate Supply Curve
What SHIFTS the Short Run Phillips Curve (SRPC) to the Left or to the Right?
Short Run Aggregate Supply Shocks!
A NEGATIVE SUPPLY shock (SRAS shifts to the LEFT) will shift the SRPC to the RIGHT!
A POSITIVE SUPPLY shock (SRAS shifts to the RIGHT) will shift the SRPC to the LEFT
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
Let start over to illustrate how a
Shift in the SRAS curve will cause a
Shift of the Phillips Curve.
“B”
For simplicity I will take out the LRAS,
but Understand it still exits.
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
SRAS
“B”
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Assume a Negative Supply Shock
Price
SRAS curve shifts to the LEFT and we establish a new equilibrium a
Level
At Point “B”—”COST PUSH INFLATION”
Inflation
SRAS 1
SRAS
Price Level INCREASES
RGDP DECREASES
Unemployment INCREASES
“B”
Opps!---this does not conform to our nice and neat
INVERSE relationship between Inflation and Unemployment.
It appears now to be a DIRECT relationship
PL 1
“B”
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 1 Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Notice Point “B” on AD/AS
is at a HIGHER
Price
Level of Inflation AND a HIGHER
Level level
Of Unemployment RELATIVE to Point “A”.
If we plot this point on the Phillips Curve Graph
We will find that point is ABOVE and to the LEFT of “A”
“B”
“B”
PL 1
SRAS 1
SRAS
“B”
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 1 Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
SRAS 1
We have established ONE Inflation/Unemployment Point
that now lies to the RIGHT of the SRPC*.
“B”
“B”
PL 1
SRAS
“B”
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 1 Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Price
If policies were implemented to shift AD either to the
Levela NEW Phillips Curve
LEFT or RIGHT we would create
that lies to the RIGHT of the previous one (SRPC*)
“B”
“B”
PL 1
SRAS 1
SRAS
“B”
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 1 Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
SRAS 1
SRAS
Helpful Hint: If SRAS curve shifts to the LEFT
Then the Phillips Curve will shift to the RIGHT
“B”
“B”
PL 1
“B”
“A”
“A”
PL*
“C” SRPC 1
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 1 Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
SRAS 1
SRAS
How it looks cleaned up!!
PL*
SRPC 1
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
RGDP 1 Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
“B”
SRAS
What happens to the Phillips Curve
If there is a POSTIVE Supply Shock?
“A”
“A”
PL*
“C”
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Assume a Positive Supply Shock
Price
SRAS curve shifts to the RIGHT and we establish a new equilibrium a
Level
At Point “B”
Inflation
SRAS
SRAS 1
Price Level DECREASES
RGDP INCREASES
Unemployment DECREASES
“B”
Opps!---this does not conform to our nice and neat
INVERSE relationship between Inflation and Unemployment.
It appears now to be a DIRECT relationship
“A”
“A”
PL*
“C”
“B”
PL 1
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
Fe RGDP
1
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Notice Point “B” on AD/AS
is at a LOWER
Price
Level of Inflation AND a LOWER
Level level
of Unemployment RELATIVE to Point “A”.
If we plot this point on the Phillips Curve Graph
we will find that point is BELOW and to the LEFT of “A”
SRAS
SRAS 1
“B”
“A”
“A”
PL*
“B”
“C”
“B”
PL 1
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
Fe RGDP
1
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
We have established ONE Inflation/Unemployment Point
that now lies to the LEFT of the SRPC*.
SRAS
SRAS 1
“B”
“A”
“A”
PL*
“B”
“C”
“B”
PL 1
AD
SRPC*
UR 1
UR* UR 2
(NRU)
Unemployment
Fe RGDP
1
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Price
If policies were implemented to shift AD either to the
Levela NEW Phillips Curve
LEFT or RIGHT we would create
that lies to the LEFT of the previous one (SRPC*)
SRAS
SRAS 1
“B”
“A”
“A”
PL*
“B”
“C”
“B”
PL 1
AD
SRPC*
SRPC 1
UR 1
UR* UR 2
(NRU)
Unemployment
Fe RGDP
1
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
SRAS
SRAS 1
Helpful Hint: If SRAS curve shifts to the RIGHT
Then the Phillips Curve will shift to the LEFT
“B”
“A”
“A”
PL*
“B”
“C”
“B”
PL 1
AD
SRPC*
SRPC 1
UR 1
UR* UR 2
(NRU)
Unemployment
Fe RGDP
1
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
SRAS
SRAS 1
Here is how it looks cleaned up!
AD
SRPC*
SRPC 1
UR 1
UR* UR 2
(NRU)
Unemployment
Fe RGDP
1
RGDP
Quantity of Real GDP
Long Run Phillips Curve
Easy, Cheesey!!
In the long run, there is no trade off between Inflation and
Unemployment
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
We will start out at our neutral position.
The NRU and Price Stability---the “NAIRU”
“A”
“A”
I*
PL*
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
Assume AD increases and shifts to the RIGHT.
Price Level INCREASES
RGDP INCREASES
Unemployment DECREASES
Our new equilibrium is at Point “B” (note this!)
Absent any policy interventions we will see how
the “Self-Correcting Mechanism” will work to
“A”
get the economy back to full-employment
I*
“B”
PL 1
“A”
PL*
AD 1
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
We already know that this movement along the SRAS Curve
IN THE SHORT RUN and will create movement ALONG a
Short Run Phillips Curve (Up and to the Left).
However, now we want to transition to the LONG RUN situation.
“B”
PL 1
“A”
“A”
I*
PL*
AD 1
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
The economy is experiencing INFLATION
Price
AND the Actual Unemployment Rate is now
Level
BELOW the NRU.
LRAS
SRAS
This going to create conditions for “Wage Inflation”
Remember: Wages are an input into the Cost of Producing
When input prices INCREASE what happens to SRAS?
“B”
PL 1
“A”
“A”
I*
PL*
AD 1
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
A NEGATIVE SUPPLY SHOCK.
SRAS shifts to the LEFT
Inflation
Aggregate Demand/Aggregate Supply
Price
Level
Price Level INCREASES
RGDP DECREASES
Unemployment DECREASES
LRAS SRAS 1
SRAS
“C”
New Equilibrium after the LONG TERM
ADJUSTMENT is at Point “C”
PL 2
“B”
NOTE:We have returned to
Full-employment RGDP and the NRU
BUT at a HIGHER Price Level “A”
than before
PL 1
I*
PL*
“A”
AD 1
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
“C”
I1
LRAS SRAS 1
Plot Point “C” from AD/AS
on the Phillips Curve
SRAS
“C”
PL 2
“B”
PL 1
“A”
“A”
I*
PL*
AD 1
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Phillips Curve
Inflation
Point “C” represents below
Represents a HIGHER Price
Level back at the NRU
Aggregate Demand/Aggregate Supply
Price
Level
“C”
I1
LRAS SRAS 1
SRAS
“C”
PL 2
“B”
PL 1
“A”
“A”
I*
PL*
AD 1
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
RGDP 1
Quantity of Real GDP
Now, Let’s look at it from the perspective of a DECREASE in AD
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
We will start out at our neutral position.
“C”
I1
The NRU and Price Stability---the “NAIRU”
“A”
“A”
I*
PL*
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Assume AD decreases and shifts to the LEFT.
Aggregate Demand/Aggregate Supply
Price
Level
LRAS
SRAS
Price Level DECREASES
RGDP DECCREASES
Unemployment INCREASES
“C”
Our new equilibrium is at Point “B” (note this!)
Absent any policy interventions we will see how
the “Self-Correcting Mechanism” will work to
get the economy back to full-employment
“A”
“A”
I*
PL*
“B”
PL 1
AD*
AD 1
UR*
(NRU)
Unemployment
RGDP 1
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Price
The economy is experiencing RECESSION
AND the Actual Unemployment RateLevel
is now
ABOVE the NRU.
LRAS
SRAS
This going to create conditions for “Wage Deflation”
“C”
Remember: Wages are an input into the Cost of Producing
When input prices DECREASE what happens to SRAS?
“A”
“A”
I*
PL*
“B”
PL 1
AD*
AD 1
UR*
(NRU)
Unemployment
RGDP 1
Fe
RGDP
Quantity of Real GDP
Phillips Curve
A POSITIVE SUPPLY SHOCK.
Inflation
SRAS shifts to the RIGHT
Aggregate Demand/Aggregate Supply
Price
Level
LRAS
SRAS
SRAS 1
Price Level DECREASES
RGDP INCREASES
Unemployment DECREASES
“C”
I1
I*
New Equilibrium after the LONG TERM
ADJUSTMENT is at Point “C”
NOTE:We have returned to
Full-employment RGDP and the NRU
“A”
BUT at a LOWER Price
Level than before
“A”
PL*
“B”
PL 1
AD*
“C”
PL 2
UR*
(NRU)
Unemployment
AD 1
RGDP 1
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Aggregate Demand/Aggregate Supply
Price
Level
Inflation
LRAS
SRAS
SRAS 1
Plot Point “C” from AD/AS
on the Phillips Curve
“A”
“A”
I*
PL*
I2
PL 1
“C”
UR*
(NRU)
Unemployment
“B”
AD*
“C”
PL 2
AD 1
RGDP 1
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
Aggregate Demand/Aggregate Supply
Price
Level
LRAS*
LRAS
SRAS
If we connect our points on the PHILLIP CURVE
We will derive the LONG RUN PHILLIPS CURVE
I*
“A”
PL*
“A”
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
Phillips Curve
Inflation
LRAS*
Aggregate Demand/Aggregate Supply
Price
Level
LRAS
SRAS
The Long Run Phillips Curve suggests
There is ON Long Term Trade-off between
Inflation and Unemployment
I*
“A”
PL*
“A”
AD*
UR*
(NRU)
Unemployment
Fe
RGDP
Quantity of Real GDP
What can shift the LONG RUN PHILLIPS CURVE?
Anything that might change the Natural Rate of Unemployment
Remember: The NRU is comprised of
a. Frictional Unemployment
b. Structural Unemployment
Policies that INCREASE these types of unemployment will INCREASE
the NRU and the LONG RUN PHILLIPS CURVE will shift to the RIGHT.
Policies that DECREASE these types of unemployment will DECREASE
the NRU and the LONG RUN PHILLIPS CURVE will shift to the LEFT
1. A change is government benefits for the unemployed—incentives or
dis-incentives to work
2. A change in education/skill level of the population
3. An increase in Labor and Capital (Technology) Productivity
Phillips Curve and The short and long
terms effects of inflaton.
• We will use as an example a sub-topic from
the #1 FRQ from the 2009 AP
Macroeconomics Test
LRAS
LRPC
Price
Level
SRAS
INFLATION
PL*
AD*
6%
RGDP*
RGDP
SRPC
NRU
UNEMPLOYMENT
The INFLATION RATE currently is 6% and the Federal Reserve believes that is too HIGH.
They decide to target 3% as a “preferred” level of Inflation.
LRPC
Price
Level
SRAS
INFLATION
PL*
AD*
6%
RGDP*
RGDP
SRPC
NRU
UNEMPLOYMENT
In order to DECREASE INFLATION the Federal Reserve would carry out the Open
Market Operation or SELLING BONDS---this will DECREASE the Money Supply and
INCREASE the FEDERAL FUNDS RATE and tend to INCREASE INTEREST RATES
throughout the Financial System.
LRPC
Price
Level
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
SRPC
NRU
UNEMPLOYMENT
INCREASING INTEREST RATES will cause AD to DECREASE
LRPC
Price
Level
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
SRPC
NRU
UNEMPLOYMENT
REAL GDP will DECREASE AND PRICE LEVEL (inflation) will DECREASE AND
Because RGDP DECREASES, UNEMPLOYMENT will INCREASE
Price
Level
LRPC
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
INFLATION is DECREASING and UMEPLOYMENT IS INCREASING---There is
MOVEMENT ALONG THE PHILLIPS CURVE IN THE SHORT RUN
Price
Level
LRPC
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
The Economy settles at a LOWER INFLATION RATE and a HIGHER
UNEMPLOYMENT RATE…
Price
Level
LRPC
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
NOTE: This is the situation in the “SHORT-RUN”---What is the LONG-TERM
EFFECT of the Federal Reserves action?
Price
Level
LRPC
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
People (and business and govt) EXPECTIONS about INFLATION are now going to
Be “built-in”---They have expectations of LOWER PRICES AND WAGES….
Price
Level
LRPC
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
This will affect a number of things BUT lets focus on WAGES
Price
Level
LRPC
SRAS
INFLATION
PL*
PL1
AD*
AD1
6%
RGDP1 RGDP*
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
Because there are expectations of LOWER Inflation then WAGES tend to
Stabilize and MAY decrease (assume this to be the case)…On the AD/AS
Graph, which curve is going to be affected???
SRAS
Price
Level
LRPC
SRAS1
INFLATION
PL*
PL1
PL2
AD*
AD1
6%
RGDP1 RGDP*
RGDP2
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
Aggregate Supply!! Cost of Production will tend to DECREASE…When C.O.P
DECREASES then Aggregate Supply will INCREASE (Shift to the Right)
SRAS
Price
Level
LRPC
SRAS1
INFLATION
PL*
PL1
PL2
AD*
AD1
6%
RGDP1 RGDP*
RGDP2
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
Price Level (inflation) has DECREASED and RGDP has INCREASED (back to the original
FE FGDP* therefore UNEMPLOYMENT has DECREASED.
SRAS
Price
Level
LRPC
SRAS1
INFLATION
PL*
PL1
PL2
AD*
AD1
6%
RGDP1 RGDP*
RGDP2
RGDP
3%
SRPC
NRU
UR1
UNEMPLOYMENT
How does this affect the Phillips Curve??? When the SRAS curve shifts to the RIGHT
The Short-Run Phillips Curve shifts to the LEFT!! Now at every level of
UNEMPLOYMENT the PRICE LEVEL will be LOWER.
SRAS
Price
Level
LRPC
SRAS1
INFLATION
PL*
PL1
PL2
AD*
AD1
6%
RGDP1 RGDP*
RGDP2
RGDP
3%
Economy is BACK to FE where AD = SRAS=LRAS
We are STILL at the NRU but at a LOWER I
INFLATION RATE!!
SRPC
NRU
UR1
UNEMPLOYMENT
With the shift of The Short Run Phillips Curve we move back to Long-Run
Equilibrium where SRPC intersect LRPC at the NRU….THE LONG RUN
PHILLIPS CURVE IS NOT GOING TO SHIFT.
The End