Alban William Housego Phillips The Phillips Curve Alban William Housego Phillips 1914-1975

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: Normally, there is a short-run 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. There is no significant trade-off between inflation and unemployment in the long run.

AD1 SRAS Price Level Real domestic output This first generalization can be seen by shifting the AD curve to the right. What would be the affect upon output/employment and upon price levels if AD shifted from AD1 to AD4? AD1 SRAS Price Level PL1 Y1 Real domestic output

AD1 AD2 SRAS Price Level PL2 PL1 o Y1 Y2 Real domestic output

SRAS Price Level o Real domestic output AD1 AD2 AD3 PL3 PL2 PL1 Y1 Y2

Assuming a constant SRAS curve, we see that high inflation is accompanied by low unemployment. AD1 AD2 AD3 AD4 SRAS PL4 PL3 PL2 PL1 o Y1 Y2 Y3 Y4 Real domestic output

Annual rate of inflation Unemployment rate (percent) We can demonstrate this short run trade off between inflation and unemployment by using the Phillips Curve. 7 6 5 4 3 2 1 Annual rate of inflation 1 2 3 4 5 6 7 Unemployment rate (percent)

Annual rate of inflation Unemployment rate (percent) Phillips Curve – there is an inverse relationship between inflation and unemployment. As inflation decreases, unemployment increases. 7 6 5 4 3 2 1 Annual rate of inflation 1 2 3 4 5 6 7 Unemployment rate (percent)

The Phillips Curve is like an inverse of the SRAS curve. PL Y/Empl. A Phillips Curve trade-off between unemployment and inflation. Increases in AD causes . . . REAL OUTPUT PRICE LEVEL UNEMPLOYMENT RATE INFLATION RATE PC AS Phillips curve AD3 AD2 AD1 C C B B A A

During the 1960s the Phillips Curve Revealed a stable relationship between inflation and unemployment.

But the 1970s and early 1980s destroyed the idea of an always-stable Phillips Curve. In those years’ inflation and unemployment rose simultaneously (stagflation). So this period proves our second generalization; AS shocks can cause both higher inflation and higher unemployment.

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.

“New Phillips Curve” 12% 8% 4% Finally, there seems to be no LR tradeoff between inflation and unemployment. When you consider decades and not single years, any rate of inflation is consistent with the natural rate of unemployment (4%). Increasing AD beyond FE may temporarily increase GDP/Y/employ. But when nominal wages eventually catch up profits will fall, ending the stimulus to produce beyond FE. 12% 8% 4% LRPC SRPC3 c3 Inflation SRPC2 “New Phillips Curve” b3 c2 SRPC1 b2 C1 Inflat. Gap Recess. Gap Unemployment b1 0 2% 4% 6% 8%

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 (4%). A stable Phillips Curve with the dependable series of unemployment-rate-inflation-rate tradeoffs simply does not exists in the LR. Any rate of inflation can occur with the 4% natural rate of unemployment. Thus, the FED has chosen to fight inflation rates before they worry about unemployment. 12% 8% 4% LRPC SRPC3 c3 Inflation SRPC2 b3 c2 SRPC1 b2 C1 Inflat. Gap Recess. Gap Unemployment b1 0 2% 4% 6% 8%

Start from equilibrium “A” 1. Unanticipated decrease of AD1 to AD2 with flexible prices and wages. Equilibrium would go from “A” to ____ to ____. 2. Anticipated decrease of AD would result in “A” to ____. 3. Decrease from AD1 to AD2 if prices are flexible but wages are not. Equilibrium would move from “A” to ____. 4. Decrease from AD1 to AD2 if prices are not flexible. “A” to __. C D C D E

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