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The Phillips Curve
•In
1958, British economist A.W. Phillips wrote an
article that showed the negative correlation of the
rate of unemployment and wages
•In the U.S. two economists, Paul Samuelson and
Robert Solow, recognized a similar correlation
between unemployment and price levels and
dubbed it the Phillips curve.
The Phillips curve illustrates the short-run
relationship between inflation and unemployment.
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The Phillips Curve...
Inflation
Rate
(percent
per year)
Phillips curve
0
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Unemployment
Rate (percent)
Unemployment and Inflation
 Society
faces a short-run tradeoff between
unemployment and inflation.
 If policymakers expand aggregate demand,
they can lower unemployment, but only at
the cost of higher inflation.
 If they contract aggregate demand, they
can lower inflation, but at the cost of
temporarily higher unemployment.
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The Phillips Curve...
Inflation
Rate
(percent
per year)
B
6
A
2
Phillips curve
0
4
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7
Unemployment
Rate (percent)
AD/AS & the Phillips Curve
The Phillips curve shows the combination
of options of inflation and unemployment
that arise as AD shifts along the SRAS.
 Shifts of the AD curve as the result of
monetary policy lead to movement along
the Phillips curve

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How the Phillips Curve is Related to the Model of
Aggregate Demand and Aggregate Supply...
(a) The Model of AD and AS
Price Level
106
102
Short-run
AS
Inflation Rate
(percent per
year)
B
A
High AD
Low AD
0
7,500
(unemployment
is 7%)
(b) The Phillips Curve
8,000
(unemployment
is 4%)
6
2
0
B
A
7
4
(output is (output is
8,000)
7,500)
Phillips curve
Unemployment
Rate (percent)
Shifts in AD push unemployment and inflation in opposite
directions
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The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps
concluded that inflation and
unemployment are unrelated in the long
run.
 As
a result, the long-run Phillips curve is
vertical at the natural rate of
unemployment.
 Monetary policy could be effective in the
short run but not in the long run.
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The Long-Run Phillips Curve...
Inflation
Rate
LR PC3
0
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LR PC1
LR PC2
Natural
rate of
unemploy
Unemployment
Rate
Factors of Natural Unemployment
Rate
Minimum wage laws – tends to raise
unemployment rate
 Union power – tends to raise
unemployment rate
 Unemployment benefits – tends to raise
unemployment rate
 Job training programs – tends to lower
unemployment rate
 Job search assistance – tends to lower
unemployment rate

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Expected Inflation & Actual Inflation
Long-run
Phillips Curve
Inflation
Rate
Actual Rate of
Inflation
6%
4%
B
A
Expected Rate of
Inflation
C
0
Natural Rate of
Unemployment
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Unemployment
Rate
Expected Inflation and Actual Inflation
The
short-run trade off exists because only
because of misperceptions. In other words
we expect overall price levels to be
increasing at a lower rate then they actually
are.
In the short-run actual inflation may
deviate from expected inflation. This causes
the short-run decrease in unemployment.
The
expected rate of inflation is found at the
intersection of the LRPC and the SRPC.
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Expected Inflation & Actual Inflation
Long-run
Phillips Curve
Inflation
Rate
6%
4%
B
A
Expected Rate of
Inflation
C
0
Natural Rate of
Unemployment
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Actual Rate of
Inflation
Unemployment
Rate
Expected Inflation and Actual Inflation



Any change in AD will change the inflation
rate and move the economy along the Phillips
curve, causing deviations of unemployment
from its natural rate.
An increase in inflation will move the
economy upward towards point B and a
decrease in inflation will move the economy
downwards toward point C.
In both instances we deviate from the natural
rate of unemployment.
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How Expected Inflation Shifts the
Short-Run Phillips Curve...
Inflation
Rate
Long-run
Phillips curve
B
1. Expansionary
policy moves
the economy up
along the shortrun Phillips
curve...
0
2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
curve shifts to the right.
C
Short-run Phillips curve with
high expected inflation
A
Short-run Phillips curve with
low expected inflation
Natural rate of
unemployment
Unemployment
Rate
Disinflationary Monetary Policy



In the long-run the actual inflation rate becomes
the expected rate causing the AS curve and the
Phillips curve to shift.
If monetary or fiscal policy increases AD then in
the short-run price levels/inflation rise and
output increases and unemployment decreases.
In the long-run inflationary expectations rise to
meet the actual inflationary levels (employees
ask for wage increases) and the AS curve and
the PC curve shift.
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Disinflationary Monetary Policy in the
Short Run and the Long Run...
Inflation
Rate
Long-run
Phillips curve
A
1. Contractionary policy
moves the economy
down along the short-run
Phillips curve...
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
Rate
2. ... but in the long run, expected inflation falls
short-run
Phillips curve shifts to the left.
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An Adverse Shock to Aggregate
Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
3. …and raises the
price level…
AS2
P2
Inflation
Rate
Aggregate
supply, AS1
A
A
PC2
Aggregate
demand
0
Y2
Y1
Quantity of
Output
2. …lowers output…
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4. …giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
1. An adverse
shift in aggregate
supply…
B
P1
(b) The Phillips Curve
0
Phillips curve, PC1
Unemployment Rate
Shifts in the Phillips Curve: The Role
of Supply Shocks
 The
short-run Phillips curve also shifts
because of shocks to aggregate supply.
A supply shock is an event that directly affects firms’
costs of production and thus the prices they charge.
It shifts the economy’s aggregate supply curve...and as a
result, the Phillips curve.
 Major
adverse changes in aggregate supply
can worsen the short-run tradeoff between
unemployment and inflation.
 An
adverse supply shock gives policymakers a
less favorable tradeoff between inflation and
unemployment.
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The Supply Shocks of the 1970s...
Inflation Rate
(percent per year)
10
1980
1974
8
6
1975
1979
1978
1977
1973
4
1981
1976
1972
2
0
1
2
3
4
5
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6
7
8
9 10 Unemployment
Rate (percent)
The Cost of Reducing Inflation
 To
reduce inflation, the Fed has to
pursue contractionary monetary policy.
 When the Fed slows the rate of money
growth, it contracts aggregate demand.
 This reduces the quantity of goods and
services that firms produce.
 This leads to a rise in unemployment.
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Disinflationary Monetary Policy in the
Short Run and the Long Run...
Inflation
Rate
Long-run
Phillips curve
A
1. Contractionary policy
moves the economy
down along the short-run
Phillips curve...
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
Rate
2. ... but in the long run, expected inflation falls
short-run
Phillips curve shifts to the left.
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The Cost of Reducing Inflation
 The
sacrifice ratio is the number of
percentage points of annual output that is
lost in the process of reducing inflation
by one percentage point.
 An
estimate of the sacrifice ratio is five.
 To reduce inflation from about 10% in
1979-1981 to 4% would have required an
estimated sacrifice of 30% of annual
output!
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The Volcker Disinflation...
Inflation Rate
(percent per year)
10
A
1980 1981
1979
8
1982
6
1984
B
1987
1983
1985
C
1986
4
2
0
1
2
3
4
5
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6
7
8
9 10 Unemployment
Rate (percent)
The Volcker Disinflation
 When
Paul Volcker was Fed chairman in
the 1970s, inflation was widely viewed
as one of the nation’s foremost
problems.
 Volcker succeeded in reducing inflation
(from 10% to 4%), but at the cost of
high employment (about 10% in 1983).
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Rational Expectations
The
theory of rational expectations
suggests that people optimally use all the
information they have, including information
about government policies, when
forecasting the future.
How quickly people adjust their
expectations determines how quickly the
short-run tradeoff disappears.
This suggests that the sacrifice-ratio could
be much smaller than estimated.
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The Greenspan Era...
Inflation Rate
(percent per year)
10
8
6
1990 1991
1989
1984
1988
1985
1987
1992
1995
1994 1993
1986
4
2
00
1
2
3
4
5
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6
7
8
9 10
Unemployment
Rate (percent)
The Greenspan Era

Alan Greenspan’s term as Fed chairman
began with a favorable supply shock.
In 1986, OPEC members abandoned their
agreement to restrict supply.
 This led to falling inflation and falling
unemployment.


Fluctuations in inflation and unemployment in
recent years have been relatively small due to
the Fed’s actions.
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