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The Phillips Curve • When engaged in a lesson on the Phillip's Curve, the learner will compare and contrast the philip's curve to the aggregate supply/aggregate demand curve, in order to fully understand why there is an inverse relationship between inflation and unemployment. The Phillip's Curve will be presented in an active board lesson and student participation, with 100 percent mastery. The extended AS/AD model supports three generalizations: • In the short-run, there is a trade-off between the rate of inflation and the rate of unemployment. • AS shocks can cause both higher rates of inflation & higher rates of unemployment. • In the long run, there is no significant tradeoff between inflation and unemployment. Price Level This first generalization can be seen by shifting the AD curve to the right. What would be the affect upon output/employment AD1 SRAS and upon price levels if AD shifted from AD1 to AD4? PL1 0 Y1 Real domestic output Price Level AD1 AD2 SRAS PL2 PL1 o Y1 Y2 Real domestic output Price Level AD1 AD2 AD3 SRAS PL3 PL2 PL1 o Y1 Y2 Y3 Real domestic output Assuming a constant SRAS curve, we see that high PL4 inflation is accompanied PL3 by low unemployment. PL AD1 AD2 AD3 AD4 SRAS 2 PL1 o Y1 Y2 Y3 Y4 Real domestic output We can demonstrate this short run trade off between inflation and unemployment by using the Phillips Curve. 7 6 5 Annual rate of inflation 4 3 2 SRPC 1 0 1 2 3 4 5 6 7 Unemployment rate (percent) Phillips Curve – there is an inverse relationship between inflation and unemployment. As inflation decreases, unemployment increases. Annual rate of inflation 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 Unemployment rate (percent) The short-run Phillips Curve is an inverse of the SRAS curve. A rightward shift of AD moves up the SRAS curve; which also moves up the SRPC. Phillips curve SRAS AD3 AD2 AD1 C B A REAL OUTPUT INFLATION RATE PRICE LEVEL AS/AD SRPC C B A UNEMPLOYMENT RATE During the 1960s the Phillips Curve Revealed a stable relationship between inflation and unemployment. But during the 1970s and early 1980s this idea of an always-stable Phillips Curve was destroyed. In those years’ inflation and unemployment rose simultaneously (stagflation). So this period proved our second generalization that AS shocks can cause both higher inflation and higher unemployment. A leftward shift of AS, causing stagflation, equals a rightward shift of the SRPC. PRICE LEVEL SRAS2 SRAS1 AD1 B A REAL OUTPUT Phillips curve INFLATION RATE AS/AD SRPC1 SRPC2 B A UNEMPLOYMENT RATE The economy recovered from this period of stagflation when the Chairman of the FED, Paul Volker, followed a tight money policy aimed at reducing double-digit inflation (13% in 1979). Unemployment rose to 9.5%; but by 1983 inflation was under control (3.7%), Ig was increasing, and AD rose. Increasing AD beyond FE may temporarily increase GDP/Y/employ. Phillips curve SRAS1 LRAS AD2 AD1 B A FE REAL OUTPUT INFLATION RATE PRICE LEVEL AS/AD SRPC1 LRPC B A NRU UNEMPLOYMENT RATE But when nominal wages eventually catch up profits will fall, ending the stimulus to produce beyond FE. AD2 AD1 Phillips curve LRAS SRAS2 SRAS1 C B A FE REAL OUTPUT INFLATION RATE PRICE LEVEL AS/AD SRPC1 SRPC2 LRPC B C A NRU UNEMPLOYMENT RATE So there is no tradeoff between the rates of inflation and unemployment in the long-run. Like the LRAS curve, the LRPC is a vertical line at the economy’s natural rate of unemployment (5%). LRPC SRPC3 12% Inflation c3 SRPC2 8% 4% 0 b3 c2 b2 SRPC1 C1 2% Inflat. Gap 3% Recess. Gap b1 5% 8% Unemployment A Word From Arnold Don’t be an “econgirlie men.” Listen to Walton!