Download Phillips Curve

Deriving the Phillips Curve from AD/AS
Derive the Short and Long Run Phillips Curves
What shifts the SRPC and the LRPC
Short AND Long Term Effects of INFLATION on
the Phillips Curve
LRAS
Phillips Curve
Price
Level
..
.
B
PL1
PL*
A
C
AD1
PL2
Real GDP
FE
RGDP*
Unemployment
AD
RDP2
SRPC
RGDP1
Inflation
SRAS
The Short-Run Phillips Curve illustrates the Trade-off between Inflation
and Unemployment (derived from what is happening to RGDP) that occurs
as the AD curve traverses (either up or down) the UPWARD sloping
(Intermediate) range of SRAS.
AD
LRAS
Phillips Curve
Price
Level
..
.
B
PL1
PL*
A
C
AD1
PL2
Real GDP
FE
RGDP*
Unemployment
AD
RDP2
SRPC
AD
RGDP1
Inflation
SRAS
IMPORTANT---Movement ALONG the SRPC corresponds with AD movement ALONG the Upward
Sloping (Intermediate Range) of the SRAS Curve. The Phillips Curve is important because for
A long time—post WWII—Fiscal Policy (FP) and Monetary Policy (MP)was driven by this
relationship between inflation and unemployment
Phillips Curve
LRAS
Phillips Curve
Price
Level
..
.
B
PL1
PL*
A
C
AD1
PL2
Real GDP
FE
RGDP*
Unemployment
AD
RDP2
SRPC
AD
RGDP1
Inflation
SRAS
If Unemployment was the problem then policy makers (FP and MP) INCREASED AD to
DECREASE unemployment, but this tended to create INFLATION….
LRAS
Phillips Curve
Price
Level
..
.
B
PL1
PL*
A
C
AD1
PL2
Real GDP
FE
RGDP*
Unemployment
AD
RDP2
SRPC
AD
RGDP1
Inflation
SRAS
Or…If Inflation was the problem then policy makers (FP and MP) DECREASED AD to
DECREASE Inflation, but this tended to create Unemployment….tackling the “evil” of the
Day tended to make the other “evil” worse…
LRAS
Phillips Curve
..
.
B
.
PL1
PL*
A
C
PL2
Real GDP
FE
RGDP*
Unemployment
AD
RDP2
SRPC
AD1
AD
RGDP1
Inflation
Price
Level
SRAS
Let’s look at Point “A” on the SRPC---Notice it corresponds with the PL* and FE GDP* Which also
represents the economy at is normal Long Run Equilibrium State…Remember-LRAS represents
POTENTIAL, LONG TERM RGDP. At FE RGDP the unemployment rate is the Natural Rate of
Unemployment. In the LONG RUN no matter how much AD increases will ALWAYS Come up
against the “wall of LRAS” —NO MATTER WHAT THE PRICE LEVEL IS!!
LRAS
Phillips Curve
..
.
B
.
PL1
PL*
A
C
PL2
Real GDP
FE
RGDP*
Unemployment
AD
RDP2
SRPC
AD1
AD
RGDP1
Inflation
Price
Level
SRAS
So…if in the LONG RUN the Unemployment Rate stays at the Natural Rate of Unemployment
REGARDLESS of the PRICE LEVEL, what to you think the LONG RUN PHILLIPS CURVE is going
To look like??
Phillips Curve
10%
Inflation
..
.
LRPC
B
A
C
SRPC
0%
NRU
(5%)
Unemployment
10%
The LONG RUN PHILLIPS CURVE (LRPC) is VERTICAL at the Natural Rate of Unemployment!!
NO MATTER WHAT THE INFLATION RATE IS THE NRU STAYS THE SAME..
LRAS
Phillips Curve
LRPC
Inflation
Price
Level
..
.
.
B
π*
A
B
PL*
C
AD
SRPC
FE
Real GDP
RGDP*
NRU
Unemployment
SRAS
IMPORTANT: Point “A” on the Phillips Curve represents the LONG RUN situation where INFLATION
Is going to be stable at NRU (roughly 5%) AND Point “B” on the AD/AS graph represents the LONG
RUN situation where AD = SRAS = LRAS (Long Run Equilibrium). Embedded in the concept of FE
RGDP is the Unemployment rate is at it’s Natural Rate (roughly 5%).
LRAS
Phillips Curve
LRPC
Inflation
SRAS
Price
Level
..
.
B
π*
A
A
B
PL*
C
AD
SRPC
FE
Real GDP
RGDP*
NRU
Unemployment
IMPORTANT: The Long Run Phillips Curve is NOT the same thing as the LRAS!!! The ONLY thing
They have in common is (LRPC Explicitly and LRAS Implicitly) is the Natural Rate of
Unemployment. The LRAS can shift without causing the NRU to change AND/OR the LRPC can
shift without the LRAS curve shifting….GOT THAT…?
What SHIFTS the SRPC and the LRPC?
• The SRPC and LRPC are not static, they can
shift left or right.
• SRPC is MARRIED to the SRAS curve on our
AD/AS Model of the Economy
• WHATEVER shifts the SRAS curve causes the
SRPC to shift as well.
– However they shift in OPPOSITE directions!!!
LRAS
Phillips Curve
Inflation
π*
SRAS1
Price
Level
.
PL1
PL*
A
AD
SRPC
RGDP1
Real GDP
FE
RGDP*
NRU
Unemployment
SRAS
IMPORTANT: Lets assume the Economy experiences a NEGATIVE Supply Shock…We know this is
going to cause the SRAS curve to shift to the LEFT (“STAGFLATION”)
LRAS
Phillips Curve
Inflation
π*
.
Price
Level
PL1
PL*
A
SRAS1
.
SRPC1
SRPC*
AD
RGDP1
Real GDP
FE
RGDP*
NRU
Unemployment
SRAS
Look at our new equilibrium point on the AD/AS graph (red dot). At this new equilibrium point
If AD increased or decreased it would do so at an inflation rate HIGHER relative to the previous
Equilibrium point at ANY point on the new SRAS curve. On the Phillips Curve graph NOW at any
unemployment rate the inflation rate is going to be HIGHER relative to SRPC* …The SHORT RUN
PHILLIPS CURVE shifts to the RIGHT!! Hint: SRAS shifts LEFT, SRPC shifts RIGHT.
LRAS
Phillips Curve
Inflation
π*
.
Price
Level
PL1
PL*
A
SRAS1
.
SRPC1
SRPC*
AD
RGDP1
Real GDP
FE
RGDP*
NRU
Unemployment
SRAS
Look at our new equilibrium point on the AD/AS graph (red dot). At this new equilibrium point
If AD increased or decreased it would do so at an inflation rate HIGHER relative to the previous
Equilibrium point at ANY point on the new SRAS curve. On the Phillips Curve graph NOW at any
unemployment rate the inflation rate is going to be HIGHER relative to SRPC* …The SHORT RUN
PHILLIPS CURVE shifts to the RIGHT!! Hint: SRAS shifts LEFT, SRPC shifts RIGHT.
Short Run Phillips Curve
• What do you think is going to happen to the
SRPC in the event of a POSITIVE SUPPLY
SHOCK???
– SRAS curve shifts to the RIGHT and SRPC shifts to
the LEFT!!!!
Phillips Curve
• IMPORTANT: Whenever causes the short run
AS curve to shift INDEPENDENT of the LRAS
curve is going to cause the Phillips Curve to
shift as well.
• SRAS shifts RIGHT (positive supply shock) then
the SRPC is going to shift to the LEFT
• SRAS shifts LEFT (negative supply shock) then
the SRPC is going to shift to the RIGHT.
LONG RUN PHILLIPS CURVE
• What shifts the LONG RUN PHILLIPS CURVE?
– Changes in government benefits to the
unemployed/underemployed
– Changes in the composition of the Labor force
– Changes in Supply-Side policies
Phillips Curve
10%
LRPC LRPC1
Inflation
SRPC
0%
NRU NRU1
10%
(5%) (7%)
Unemployment
Changes in Govt Benefits towards the UNEMPLOYED and the UNDEREMPLOYED
If the Govt. INCREASES the benefits they pay to the unemployed/underemployed in
general this produces a higher level of FRICTIONAL unemployment. People tend to stay
Unemployed for longer periods of time because the replacement income they receive
from the govt. is closer to their lost income…In other words, the incentive to look for a
Job is diminished and the tendency to stay unemployed increases..
The LONG RUN PHILLIPS CURVE SHIFTS TO THE RIGHT
Phillips Curve
10%
LRPC1 LRPC
Inflation
SRPC
0% NRU1 NRU
10%
(3%) (5%)
Unemployment
Changes in Govt Benefits towards the UNEMPLOYED and the UNDEREMPLOYED
If the Govt. DECREASES the benefits they pay to the unemployed/underemployed in
general this produces a lower level of FRICTIONAL unemployment. People tend to stay
Unemployed for shorter periods of time because the replacement income they receive
from the govt. is much LESS then their original income…In other words, the incentive to
look for a job is INCREASES and the tendency to stay unemployed DECREASES...
The LONG RUN PHILLIPS CURVE SHIFTS TO THE LEFT
Frequency
Time
Annual
2004
Quarterly
2005
2006
2006
Q3-2006
2007
Q4-2006
Q1-2007
Country
Australia
i
5.5
5.1
4.9
4.8
4.6
4.5
Austria
i
4.8
5.2
4.8
4.7
4.5
4.5
Belgium
i
8.4
8.4
8.2
8.1
7.9
7.7
Canada
i
7.2
6.8
6.3
6.4
6.2
6.1
Czech Republic
i
8.3
7.9
7.2
7.1
6.6
6.3
Denmark
i
5.5
4.8
3.9
3.7
3.6
3.4
Finland
i
8.9
8.4
7.7
7.8
7.4
6.9
France
i
9.6
9.7
9.4
9.3
9.1
8.8
Germany
i
9.5
9.4
8.4
8.4
7.9
7.2
Greece
i
10.5
9.9
8.9
8.7
8.6
..
Hungary
i
6.1
7.2
7.5
7.6
7.7
8
Ireland
i
4.5
4.3
4.4
4.4
4.2
4
Italy
i
8
7.7
6.8
6.6
6.5
..
Japan
i
4.7
4.4
4.1
4.1
4.1
4
Korea
i
3.7
3.7
3.5
3.4
3.4
3.2
Luxembourg
i
5.1
4.5
4.8
4.7
4.8
4.9
Netherlands
i
4.6
4.7
3.9
3.9
3.7
3.5
New Zealand
i
3.9
3.7
3.8
3.8
3.7
3.8
Norway
i
4.4
4.6
3.5
3.3
2.9
2.7
Poland
i
19
17.7
13.8
13.4
12.6
11.8
Portugal
i
6.7
7.6
7.7
7.6
8
8.1
Slovak Republic
i
18.2
16.2
13.4
13.1
12.4
11.1
Spain
i
10.6
9.2
8.5
8.3
8.4
8.2
Sweden
i
6.3
7.3
7
6.9
6.5
6.5
Switzerland
i
4.4
4.5
4
3.9
3.8
3.7
i
4.7
4.8
5.3
5.4
5.4
..
United Kingdom
Why do some other major economies have
persistently higher unemployment rates
than the U.S.
• Government policies
are a major culprit
 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