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Unit 3: Aggregate Demand and Supply and Fiscal Policy 1 The Phillips Curve Shows tradeoff between inflation and unemployment. What happens to inflation and unemployment when AD increase? In general, there is an inverse relationship between unemployment and inflation 3 Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation When there is a recession, unemployment is high but inflation is low 5% 1% SRPC 2% 9% Unemployment 4 Short Run Phillips Curve What happens when AS falls causing stagflation? Increase in unemployment and inflation Inflation 5% SRPC1 1% SRPC 2% 9% Unemployment 5 Short Run vs. Long Run What happens when AD increases? What happens in the long run? Inflation Long Run Phillips Curve In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3% SRPC1 1% SRPC 2% 5% 9% Unemployment 6 Short Run vs. Long Run In the long run there is no tradeoff between inflation and unemployment Inflation Long Run Phillips Curve 5% The LRPC is vertical at the Natural Rate of Unemployment 3% 1% 2% 5% 9% Unemployment 7 Short Run vs. Long Run What happens when AD falls? What happens in the long run? Inflation Long Run Phillips Curve 5% In the long run wages fall and there is no tradeoff between inflation and unemployment 3% 1% 2% 5% SRPC SRPC1 Unemployment 9% 8 AD/AS and the Phillips Curve AD/AS and the Phillips Curve Show what happens on both graphs if AD increase Price Level LRAS Inflation LRPC AS PLe AD1 AD QY GDPR SRPC UY Unemployment 10 AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls? Price Level LRAS Inflation LRPC AS PLe AD AD1 QY GDPR SRPC UY Unemployment 11 AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when AS falls? Price Level LRAS Inflation LRPC AS1 AS PLe SRPC1 AD QY GDPR SRPC UY Unemployment 12 AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up? Price Level LRAS AS Inflation LRPC AS1 PLe SRPC AD QY GDPR SRPC1 UY Unemployment 13 Analyzing the Economy Graphically 14 Use the following models to show full employment, a recessionary gap, and an inflationary gap. 1. PPC 2. AD/AS 3. Phillips Curve 15
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