Chapter 16 The Phillips Curve © OnlineTexts.com p. 1

The Phillips Curve The Phillips curve is a graph illustrating the inverse relationship between inflation and the unemployment rate. © OnlineTexts.com p. 2

The Early Consensus Economists in the late 1950s and 1960s thought that all the Federal Reserve or government had to do was to pick the point on the short-run Phillips curve where they wanted the economy to be positioned. Less unemployment meant living with more inflation, and vice versa. © OnlineTexts.com p. 3

Breakdown of the Short-Run Phillips Curve In the 1970s and early 1980s the short-run relationship between inflation and unemployment seemed to break down. © OnlineTexts.com p. 4

Breakdown of the Short-Run Phillips Curve A spiral pattern emerged in the Phillips curve. Economists were able to salvage the Phillips curve by realizing that a significant difference exists between the short-run and long-run relationships between inflation and unemployment. © OnlineTexts.com p. 5

The Long-Run Phillips Curve Most economists now agree that in the long run there is no tradeoff between inflation and unemployment. © OnlineTexts.com p. 6

The Long-Run Phillips Curve The long-run Phillips curve is simply a vertical line at the natural rate of unemployment, U*. Any level of inflation is consistent with the natural rate of unemployment. © OnlineTexts.com p. 7

Aggregate Demand Shifts and the Phillips Curve We can "explain" both the short-run and long-run Phillips curves by using the Aggregate Demand/Aggregate Supply model that we developed in Chapter 8. © OnlineTexts.com p. 8

Expansionary Policy, AD/AS, and the Phillips Curve © OnlineTexts.com p. 9

Contractionary Policy, AD/AS, and the Phillips Curve © OnlineTexts.com p. 10

The Role of Expectations The short-run tradeoff between inflation and unemployment is thought to work because people have an idea of what inflation expectations are going to be, and those expectations change slowly. Over time, workers learn that inflation has changed and they change their inflation expectations accordingly. © OnlineTexts.com p. 11

The Role of Expectations We can express the Phillips curve as an equation in the following manner: P = b(U* - U) + Pe where b > 0, P is the inflation rate, and Pe is the expected rate of inflation. © OnlineTexts.com p. 12

The Role of Expectations The long-run Phillips curve equation suggests that the inflation rate is entirely determined by inflation expectations. When inflation expectations rise, the Phillips curve shifts upward. © OnlineTexts.com p. 13

Shifts in the AS Curve and the Phillips Curve When the Aggregate Supply curve shifts, we can get very different results in the Phillips curve than when the Aggregate Demand curve shifts. An oil shock, for example, can produce stagflation. © OnlineTexts.com p. 14

Shifts in the AS Curve and the Phillips Curve Policy makers are left with difficult decisions once the economy moves to point B. © OnlineTexts.com p. 15

Is the Phillips Curve Dead? Despite being reconstructed in the 1970s, the Phillips curve relationship was suspiciously absent again in the mid- to late-1990s. © OnlineTexts.com p. 16

Is the Phillips Curve Dead? Two viewpoints on the relevance of the Phillips Curve: The relationship between inflation and unemployment has disappeared altogether. Special circumstances such as an increase in labor productivity account for the lack of a relationship. The relationship will return once these factors subside. One consensus that certainly has emerged is that the Phillips curve is not a reliable tool to forecast inflation or unemployment. © OnlineTexts.com p. 17