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CHAPTER 33
Inflation and the Phillips Curve
The first few months or years of inflation, like the first few
drinks, seem just fine. Everyone has more money to spend and
prices aren’t rising quite as fast as the money that’s available.
The hangover comes when prices start to catch up.
— Milton Friedman
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Inflation
and the Phillips Curve
33
Inflation
• Inflation: a rise in the price level
• Measured with price indexes
33-2
Inflation
and the Phillips Curve
33
Effects of Inflation
• Unexpected inflation redistributes income
from lenders to borrowers
• If lenders charge a nominal rate of 5%
and expect inflation to be 2%, the
expected real rate is 3%
• If inflation is actually 4%, the real rate is
only 1%
33-3
Inflation
and the Phillips Curve
33
Expectations of Inflation
• Rational expectations: predicted by
economists’ models
• Adaptive expectations: based on the past
• Extrapolative expectations: expectations that
a trend will continue
33-4
Inflation
and the Phillips Curve
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Productivity, Inflation, and Wages
• Changes in productivity and changes in wages
determine if inflation is coming
• There will be no inflationary pressures if wages
and productivity increase at the same rate
• Inflation = Nominal wage increases Productivity growth
33-5
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Inflation
and the Phillips Curve
Nominal Wages, Productivity, and Inflation
• When nominal wages increase by more than
the growth of productivity, the SRAS curve
shifts up (left), resulting in inflation
• When nominal wages increase by less than
the growth of productivity, the SRAS curve
shifts down (right), resulting in deflation
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Inflation
and the Phillips Curve
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Theories of Inflation
• Theory #1: The quantity theory of inflation
emphasizes the connection between money
and inflation
• If the money supply rises, the price level
rises
• If the money supply does not rise, the price
level will not rise
33-7
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Inflation
and the Phillips Curve
Theories of Inflation
• Theory #2: The institutional theory
emphasizes the relationship between market
structure and price-setting institutions and
inflation
• It is easier for firms to raise prices than to
lower them and they do not take the effect
of this into account
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Inflation
and the Phillips Curve
Theories of Inflation
• As workers push for higher nominal wages
(or a firms raise prices) more people want
higher wages (or more firms raise their
prices)
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Inflation
and the Phillips Curve
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The Quantity Theory of Money and Inflation
• The equation of exchange is: MV = PQ
• M = Quantity of money
• V = Velocity of money
• Q = Real GDP
• P = Price level
33-10
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Inflation
and the Phillips Curve
The Quantity Theory of Money and Inflation
• Velocity of money is the number of times per
year, on average, a dollar goes around to
generate a dollar’s worth of income
•Velocity = Nominal GDP
Money Supply
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Inflation
and the Phillips Curve
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The Quantity Theory of Money and Inflation
• Three assumptions of the quantity theory:
1. Velocity is constant due to the structure of
the economy
2. Real output (Q) is independent of money
supply
• Q is autonomous (determined by
outside forces in the economy)
33-12
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Inflation
and the Phillips Curve
The Quantity Theory of Money and Inflation
3. Causation goes from money to prices
• The price level varies in response to
changes in the quantity of money
• The quantity theory of money is stated
as %∆M
%∆P
• If the money supply goes up 5% so does
the price level
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Inflation
and the Phillips Curve
33
Central Banks and the Money Supply
• If the central bank must buy government
bonds to finance a government deficit, the
money supply increases and inflation may
occur
33-14
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Inflation
and the Phillips Curve
Central Banks and the Money Supply
• Central banks have to make a policy choice:
• Bailing out their governments with
expansionary monetary policy
OR…
• Do nothing and risk a recession
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Inflation
and the Phillips Curve
33
Institutional Theory of Inflation
• According to the institutionalists, increases in
prices force the government to increase the
money supply or cause unemployment
• MV
PQ
33-16
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Inflation
and the Phillips Curve
Institutional Theory of Inflation
• In this theory, inflation is caused by the way
in which prices as well as wages are set
• For example: if wages are increasing so is
the price level
• At this point, the government must
decide whether or not to increase the
money supply
–If it increases it, inflation is accepted
–If not, unemployment increases
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Inflation
and the Phillips Curve
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Demand-Pull Inflation
• Demand-pull inflation: inflation that occurs
when the economy is at or above potential
output (creates inflationary gap)
• Characterized by shortages of goods and
workers
• Associated with the quantity theory of
money/inflation
33-18
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Inflation
and the Phillips Curve
Cost-Push Inflation
• Cost-push inflation: inflation that occurs when
the economy is below potential output
• Usually caused by an increase in input costs
of one of the factors of production
• No excess demand but excess supply may
exist
• Firms that raise prices may not sell their
goods
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Inflation
and the Phillips Curve
Cost-Push Inflation
• Example: 1970s when OPEC raised the price
of oil
• Associated with the institutional theory of
Inflation
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Inflation
and the Phillips Curve
Addressing Inflation with Monetary Policy
•Some policymakers believe there is a tradeoff
between inflation and unemployment
•Government can:
•Keep output high (AD0; inflationary gap)
• Low unemployment
• Higher inflation
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Inflation
and the Phillips Curve
Addressing Inflation with Monetary Policy
•Decrease AD ( to AD1)
• Low inflation
• Higher unemployment
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Inflation
and the Phillips Curve
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Addressing Inflation with Monetary Policy
Price level
LRAS
SRAS1
Inflationary
pressure
P1
SRAS0
P0
AD0
P2
AD1
Q1
Q0
Real output
33-23
Inflation
and the Phillips Curve
33
The Phillips Curve
• This concept can be expressed in a new graph:
the Phillips Curve
33-24
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Inflation
and the Phillips Curve
The Short-run Phillips Curve
• The short-run Phillips curve is a downwardsloping curve showing the relationship
between inflation and unemployment when
expectations of inflation are constant
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Inflation
and the Phillips Curve
Draw the Graph: Short-run Phillips Curve
Inflation
Short-run
Phillips curve
(SRPC)
Unemployment rate
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Inflation
and the Phillips Curve
33
The Short-Run Phillips Curve
• Actual inflation depends on both supply and
demand forces and on how much inflation
people expect
• At all points on the short-run Phillips curve
(SRPC), expectations of inflation (the rise in the
price level that the average person expects) are
fixed
33-27
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Inflation
and the Phillips Curve
The Long-Run Phillips Curve
• At all points on the long-run Phillips curve,
expectations of inflation are equal to actual
inflation
• The long-run Phillips curve (LRPC) is vertical
at the natural rate of unemployment
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Inflation
and the Phillips Curve
33
Draw the Graph: The Long-run Phillips Curve
Inflation
LRPC
5%
Unemployment rate
33-29
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Inflation
and the Phillips Curve
More on the Phillips Curve
• The sustainable combination of inflation and
unemployment on the short-run Phillips
curve is where it intersects the long-run
Phillips curve—this is where the
unemployment rate is consistent with the
economy's potential income
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Inflation
and the Phillips Curve
33
Draw the Graph: The Short-run and Long-run Phillips
Curve
Inflation
LRPC
Point A represents the
(long-run equilibrium)
A
5%
SRPC
5%
Unemployment rate
33-31
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Inflation
and the Phillips Curve
Inflation and the AS/AD Model
Price level
LRAS
SRAS3
SRAS2
SRAS1
C
B
AD2
A
AD1
Real GDP
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•Start at point A (long-run
equilibrium)
•AD moves from AD1 to
AD2—above its potential
•Firms then raise prices
(SRAS2, point B)
•At SRAS2 we are still above
potential
•This causes SRAS to shift up
to SRAS3, point C—we see
the economy is in
equilibrium again
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Inflation
and the Phillips Curve
Inflation and the Phillips Curve
Refer to Figure 33-5 A
and B in the text
Inflation
Long-run Phillips Curve
SRPC1 SRPC2
4
•SRPC1 shifts to SRPC2
when the economy is
trying to account for the
inflationary gap at point B
on the AS/AD graph
•Then, when SRAS2 shifts
to SRAS3, we are at point C
on the LRPC and back at
long-run equilibrium in the
AS/AD model
C
B
2
0
4.5
McGraw-Hill/Irwin
5.5
A
Unemployment rate
Colander, Economics
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Inflation
and the Phillips Curve
33
AS/AD and the Phillips Curve
#1. Show what happens on both graphs if AD increases
LRPC
LRAS
Price Level
Inflation
SRAS
P2
6%
P1
5%
AD2
AD1
Y1 Y2
McGraw-Hill/Irwin
Result: Higher
inflation and lower
unemployment
Real GDP
Colander, Economics
SRPC
U1 UY Unemployment
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AS/AD and the Phillips Curve
#2. Correctly draw the LRPC and SRPC with a recessionary
gap. What happens when AD falls?
Inflation
and the Phillips Curve
LRAS
LRPC
Price Level
Result: Lower
inflation and
higher
unemployment
Inflation
SRAS
P1
6%
P2
5%
AD2
Y2
McGraw-Hill/Irwin
Y1
SRPC
AD1
Real GDP
Colander, Economics
UY
U1 U2
Unemployment
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AS/AD and the Phillips Curve
#3. Correctly draw the LRPC and SRPC at full employment.
What happens when SRAS falls?
Inflation
and the Phillips Curve
LRAS
Inflation
Price Level
Inflation and
LRPC unemployment
increase
SRAS2
SRAS1
PL2
6%
PL1
5%
SRPC2
AD
Y2 Y1
McGraw-Hill/Irwin
Real GDP
Colander, Economics
SRPC1
UY U1
Unemployment
36
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AS/AD and the Phillips Curve
#4. Correctly draw the LRPC and SRPC with a recessionary
gap. What happens when SRAS increases?
Inflation
and the Phillips Curve
LRAS
LRPC
SRAS1
Price Level
SRAS2
7%
PL1
SRPC1
PL2
5%
SRPC2
AD
Y1
McGraw-Hill/Irwin
Y2
Real GDP
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UY U1
Unemployment
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Inflation
and the Phillips Curve
33
Chapter Summary
• The winners in inflation are people who can raise their
wages or prices and still keep their jobs or sell their
goods
• The losers are people who can’t raise their wages or
prices
• People form expectations in many ways
• Three ways are to base expectations on economic
models, on an average of the past, or on trends
• A basic rule to predict inflation is: Inflation equals
nominal wage increases minus productivity growth
33-38
Inflation
and the Phillips Curve
33
Chapter Summary
• The equation of exchange is MV = PQ
• When velocity is constant, real output is
independent of the money supply, and
causation goes from money to prices
• The equation of exchange becomes the quantity
theory, and it predicts that the price level varies in
direct response to changes in the quantity of money
• That is %∆M leads to an equal %∆P
33-39
Inflation
and the Phillips Curve
33
Chapter Summary
• Central banks sometimes print money knowing
that it will lead to inflation because the
alternative might be a breakdown of the economy
• The institutional theory of inflation sees the
source of inflation in the wage-and-price setting
institutions
• Institutionalists see the direction of causation
going from price increases to money supply
increases
33-40
Inflation
and the Phillips Curve
33
Chapter Summary
• The long-run Phillips curve is vertical, and it allows
expectations of inflation to change
• The short-run Phillips curve is downward sloping,
holds expectations constant, and shifts when
expectations change
• Quantity theorists see a long-run trade-off between
inflation and growth, but institutionalists are less
sure about this trade-off
33-41