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Aggregate Supply and the Phillips Curve AD/AS and the Phillips Curve • The Aggregate Demand/Supply Model illustrates the short-run relationship between price level and employment. As price level rises, employment increases. • The Phillips curve illustrates the short-run relationship between inflation and unemployment. As price level rises, unemployment decreases. • Movement up along the supply curve is mirrored by movement up along the Phillips curve. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply in the Short-run (a) The Model of AD and AS Price Level SRAS 106 B 102 Inflation Rate (% per year) High AD A 7,500 8,000 B 6 A 2 Low AD 0 (b) The Phillips Curve Output 0 Phillips curve 4 7 Unemployment Rate (%) Shifts in the Phillips Curve: The Role of Supply Shocks The short-run Phillips curve shifts because of shocks to aggregate supply. A supply shock is an event that directly affects firms’ costs of production and thus their ability to produce. An increase in the price of oil increases production costs and forces employers to lay off workers. This is shown by a leftward shift of the AS curve and an upward shift of the Phillips curve (higher prices and higher unemployment) A positive supply shock would move AS to the right and shift the Phillips curve downward- lower prices and lower unemployment An Adverse Shock to Aggregate Supply... (a) The Model of Aggregate Demand and Aggregate Supply Price Level 3. …and raises the price level… (b) The Phillips Curve Inflation Rate AS2 Aggregate supply, AS1 P2 A P1 B 1. An adverse shift in aggregate supply… B A PC2 Aggregate demand 0 Y2 Y1 2. …lowers output… Quantity of Output 4. …creating a less favorable tradeoff between unemployment and inflation. 0 Phillips curve, PC1 Unemployment Rate The Long Run Phillips Curve • The Long Run Phillips Curve illustrates the Natural Rate of Unemployment • Changes in price level do not affect the LRPC, but the LRPC can change (shift) if there are changes in: – – – – – Minimum wage Collective bargaining laws Unemployment insurance Job training programs Job search assistance The Long-Run Phillips Curve... Inflation Rate 0 LRPC1 LRPC2 Natural rate of unemployment Unemployment Rate Expectations and the Short-Run Phillips Curve Expected inflation measures how much people expect the overall price level to change. It is shown graphically as the point on the Short-run Phillips Curve that intersects the Long-run Phillips Curve. Expected Inflation & Actual Inflation Long-run Phillips Curve Inflation Rate B 6% 4% Expected Rate of Inflation A C 0 Natural Rate of Unemployment Unemployment Rate Expectations and the Short-run Phillips Curve • If actual inflation is higher than expected inflation then unemployment decreases. • This is shown by movement upward and along a stable Phillips Curve. • If actual inflation is lower than expected inflation then unemployment increases, movement down along the PC. • In both instances we deviate from the natural rate of unemployment. Expected Inflation & Actual Inflation Long-run Phillips Curve Inflation Rate Actual Rate of Inflation B 6% 4% Expected Rate of Inflation A C 0 Natural Rate of Unemployment Unemployment Rate Expectations and the Short-Run Phillips Curve In the long run, expected inflation adjusts to • • • changes in actual inflation. --This is shown by a shift in the entire short-run Phillips Curve. --If inflationary expectations are now higher the curve shifts right. This shows a worsening tradeoff between inflation and unemployment. --If inflationary expectations are now lower the curve shifts left. This is an improvement in the trade-off. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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