Download short and long run Phillips curve

Chapter 54: HL extension – short and long run
Phillips curve (2.3)




The SR Phillips curve – possible trade-off
Shift of SR Phillips curve
LR Phillips curve – no trade off in LR
Natural rate of unemployment and full employment level of output
Possible
relationships
between
unemployment and
inflation
•
Discuss, using a short-run Phillips curve diagram, the view that there
is a possible trade-off between the unemployment rate and the
inflation rate in the short-run
•
Explain, using a diagram, that the short-run Phillips curve may shift
outwards resulting in stagflation (caused by a decrease in SRAS due
to factors including supply shocks)
•
Discuss, using a diagram, the view that there is a long-run Phillips
curve which is vertical at the natural rate of unemployment and
therefore there is no trade off between the unemployment rate and
the inflation rate in the long run
•
Explain that the natural rate of unemployment is the rate of
unemployment that exists when the economy is producing at the full
employment level of output
Figure 54.3 The AS curve and the Phillips curve
I: Keynesian AS
Price
level
(index)
II: Phillips Curve
Inflation (%)
AS
B
P1
i1
B
A
P0
P2
AD1
C
AD0
i0
i2
A
C
PC
AD2
Y2 Y0 Y1
GDPreal/t
U1 U0
U
2
Unemployment
(%)
The Phillips curve shows the ‘trade-off’ between inflation and
unemployment. Stimulatory policies which increase aggregate demand
(AD0 to AD1) lower unemployment (U0 to U1) but increase the inflation
rate (i0 to i1).

Assume that prices have been increasing at a stable rate at an output of Y0 (diagram I) and U0
(diagram II) whereupon expansionary fiscal/monetary policies are used to increase aggregate
demand from AD0 to AD1. The increase in aggregate demand will increase national income from
Y0 to Y1, and lower unemployment from U0 to U1 (diagram II). This is shown in the diagram as a
movement from point A to B on the Phillips curve, which shows that the cost of these
expansionary policies is an increase in inflation from i0 to i1.

Conversely, fiscal/monetary contractionary policies would decrease aggregate demand, AD0 to
AD2, resulting in a lower rate of inflation, i2, but a higher level of unemployment at U2. This is
shown by the movement from point A to C in diagrams I and II.

LR Phillips curve – no trade off in LR
Figure 54.5 I – III; Supply-side shock, cost-push inflation and stagflation in the US, 1970 – 1980
II: …and cost-push spiral
during 1970s
I: Initial supply-side shock
and stagflation in 1973–74…
Price level
Price level
LRAS
LRAS SRAS8
0 SRAS75-
P8
SRAS7
4
79
0
4
P73
4
AD80
AD75-79
AD73-74
GDPreal/t
SRAS7
‘79
‘75
‘78
3
P73
4
‘74
‘80
SRAS7
P7
57
P
4
Y7 YFE
STAGFLATION!
Inflation (%)
SRAS7
5
SRAS7
3
P7
III: Phillips curve illustration
of stagflationary period
i73
‘77
‘73
PC
AD73-74
YFE
GDPreal/t
‘76
U7
3
Unemployment
(%)

The initial supply-side shock in 1973/’74 (figure I) caused inflation to rise from 6.2% in 1973 to
11% in 1974, while unemployment increased from 4.9% to 5.6% (and to 8.5% in 1975).

Consecutive periods of demand-side policies, bidding up of wages and thus increasing costs for
firms (figure II) resulted in cost-push inflation of between 5.5% and 13.5% annually, and
unemployment levels hovering between 6% and 9%.

Figure III illustrates this process in an ‘outward bound spiral’ in terms of the Phillips curve,
where it is quite evident that the relationship between inflation and unemployment has collapsed,
resulting in stagflation.
(Medium heading) The new-classical criticism of the short run Phillips
curve
Assume an economy in equilibrium at Y0 in diagram I (figure 54.6) where the natural rate of
unemployment is U0 and yearly inflation is i0, diagram II. Aggregate demand increases from AD0 to AD1,
and the economy moves from Y0 to Y1. In moving from Y0 to Y1, inflation is actually eroding real wages,
since the rate of inflation has increased from i0 to i1, shown in diagram II. Say that labourers have
negotiated for wage increases of 3% for the coming time period but that inflation during the time period
turned out to be 3.5%. This means a real wage loss of 0.5%. If workers are unaware of this fact, then they
suffer from money illusion (i.e. that the nominal wage increase is real) and will ultimately adjust demand
and spending to real wages. Aggregate demand will fall back to AD0 and deflationary pressure will lower
inflation and increase unemployment. Thus the economy would move from point B (in diagram II) along
the short run Phillips curve back to i0 and U0 at point A.
Figure 54.6 What Friedman/Phelps reacted to
I: Expansionary increase
in AD
Price
LRAS
level
II: Phillips curve trade-off
Inflation (%)
SRAS
P1
P0
B
i1
A
B
A
AD0
YNRU Y1
AD1
GDPreal/t
i0
P
C
U1 U0
Unemployment
(%)
(Type 4 Smaller heading) Labourers do not suffer from “money illusion”
It was precisely the above scenario that Friedman and Phelps opposed. According to their new-classical/
monetarist view, labourers do not suffer from money illusion and will therefore adapt to changing inflation
rates by altering their inflationary expectations.1 As pointed out in Chapter 46 (The new- classical view of
long run aggregate supply), economic agents (producers and consumers) act strongly upon expectations.
1This
is why the theory is referred to as ‘expectations augmented’; augmented means ‘enhanced’ or
‘supplemented’. In other words, economic agents’ behaviour is augmented by inflationary expectations.
(Medium heading) The LR Phillips curve (or ‘expectations-augmented
Phillips curve’)
Figure 54.7 Short and long run Phillips curve
I: Short-run Phillips curves (SRPC)
II: Long-run Phillips curve (LRPC)
Inflation
(%)
Inflation
(%)
10
B
6
6
F
A
4
7
E
5
SRPC2 (iexp =
6%)
SRPC1 (iexp =
3%)
Unemployment
(%)
B
C
3
A
4
UNRU
= 5%
SRPC3 (iexp =
10%)
SRPC2 (iexp =
6%)
SRPC1 (iexp =
3%)
Unemployment (%)
A to B: The decrease in unemployment moves the economy from point A to point B along the
SRPC1 in diagram I (figure 54.7). Since de facto inflation now exceeds anticipated inflation, and
workers’ wages are fixed for the short term, firms will be able to increase their profit margins
since final output prices have risen but nominal wages are unchanged. Note that wage rates and
wage increases were set when both employers and labourers anticipated 3% inflation!
o

D
C
3

LRPC
Now, government has achieved its aim of lowering unemployment to 4%, but since
labourers do not suffer from money illusion, point B is not a long run equilibrium point.
In due course labourers and unions adjust inflationary expectations to 6% and will bid
up wages to compensate for loss of real income. This will result in higher production
costs and dissolve the previous real increase in profits for firms.
B to C: As real costs become apparent to firms, they will cut output and decrease their demand for
labour. Simultaneously, labourers who initially offered themselves on the labour market under the
illusion that real wages were higher than turned out will withdraw from the labour market. This
will cause both markets – goods and labour – to clear, leading to point C where the economy is
once again in equilibrium and unemployment has increased to the natural rate of unemployment.
Economic agents now operate under inflationary expectations of 6%, i.e. along a new short run
Phillips curve, SRPC2 (iexp = 6%).

Natural rate of unemployment and full employment level of output
The congruence (= correspondence) between the AS-AD model and the long run Phillips curve is shown in
figure 54.8, diagrams I – IV, in an attempt to put the pieces together for you while illustrating the natural
rate of unemployment.2 In following the iteration below, keep in mind the following points:
2

When the labour market is in equilibrium then only structural, frictional and seasonal
unemployment exist.

As this unemployment exists even thought the labour market has cleared, it is the natural rate of
unemployment.

In the long run market forces tend to move unemployment levels towards market clearing, e.g. the
natural rate of unemployment.

If the economy is at the natural rate of unemployment then the economy must be in long run
equilibrium, which is to say that AD = LRAS. This is of course the level of output at the natural
rate of unemployment – YNRU.
I use these diagrams with grateful acknowledgement to Professor Klas Fregert and associate professor Lars
Jonung at Lund University.
Figure 54.8 AS-AD model and the natural rate of unemployment
II: Long-run Phillips curve
I: AD and AS in long run
Price
level
(index)
Inflation (%)
LRAS
High
inflation
P2
LRPC
C
SRAS1
i2
i1
i0
C
B
A
SRAS0
P1
P0
B
U1 UNRU
A
SRPC1 (iexp =
high)
SRPC0 (iexp =
low)
Unemployment (%)
AD1
Low
inflation
AD0
YNRU
Y1
GDPreal/
t
III & IV: Time series for unemployment and inflation
Unemployment
(%)
A
UNRU
U1
C
B
time
Inflation (%)
B
i2
i0
C
A
time
Summary and revision
1.
The short run Phillips curve (SRPC) indicates a trade-off between inflation and
unemployment – falling unemployment has been seen to correlated to rising inflation.
2.
The short run Phillips curve (SRPC) was incorporated into Keynesian thinking in the 1950s
to show the link to AD and a possible ‘menu’ of different inflation-unemployment
options.
3.
Freidman and Phelps, working in the 1960s, criticised the SRPC, claiming that people did
not suffer from money illusion and that increases in AD beyond the natural rate of
unemployment would cause inflationary bidding up of wages and a decrease in SRAS. The
economy would ultimately revert to the level of income at the natural rate of
unemployment.
4.
The supply-side shock and resulting stagflation (stagnant economy + inflation) in the mid1970s meant a break-down of the short run Phillips curve and seemed to corroborate the
existence of a vertical long run Phillips curve.
5.
The LRPC is based on the concept of adaptive expectations; people adapt to inflationary
expectations. An increase in AD beyond the natural rate of unemployment causes inflation
and a decrease in real wages. It also fuels households’ inflationary expectations. The
resulting bidding up of wages as households and labourers adapt, shifts the SRPC to the
right and ultimately general equilibrium is restored along the LRPC. Unemployment has
returned to the natural rate of unemployment but inflation has increased to a higher level.
6.
The possibility of a LRPC has some weighty ramifications for economic policy. The
supply-side school of thought has the concept of LRAS and a natural rate of unemployment
as a cornerstone for positing that only increases in long run aggregate supply can increase
real income in the long run.