Aggregate Supply and the Phillips Curve

AD/AS and the Phillips Curve The AD/AS Model shows the short-run relationship between price level and employment. As price level rises, employment increases (point A to point B on AS curve). The Phillips curve shows the short-run relationship between inflation and unemployment. As price level rises, unemployment decreases (point A to point B on Phillips curve). 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 (b) The Phillips Curve SRAS Price Level Inflation Rate (% per year) B 8,000 106 B 4 6 High AD A 7,500 102 A 7 2 Low AD Phillips curve Output Unemployment Rate (%)

Shifts in the Phillips Curve The short-run Phillips curve shifts because of shocks to aggregate supply. A negative supply shock is shown by a leftward shift of AS (AS1 to AS2) and an upward shift of the Phillips curve (PC1 to PC2). The result is 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 (b) The Phillips Curve B 4. …creating a less favorable tradeoff between unemployment and inflation. PC2 P2 3. …and raises the price level… Price Level Inflation Rate AS2 1. An adverse shift in aggregate supply… Aggregate supply, AS1 B 2. …lowers output… Y2 A A P1 Aggregate demand Phillips curve, PC1 Y1 Quantity of Output 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... LRPC1 LRPC2 Inflation Rate Unemployment Rate Natural rate of unemployment

Expectations and the Short-Run Phillips Curve Expected inflation measures how much people expect the overall price level to change. Expected inflation is the point on the Short-run Phillips Curve that intersects the LRPC (point A) Changes in the expected rate of inflation affect the short-run trade-off between inflation and unemployment and shift the short-run Phillips curve

Expected Inflation Long-run Phillips Curve Inflation Rate B A C 6 % Expected Rate of Inflation 4 % A C Short-run Phillips curve Natural Rate of Unemployment/NAIRU Unemployment Rate

Inflation and Unemployment in the Short-run If actual inflation is higher (4%) than expected inflation (6%), then unemployment decreases. This is shown by movement upward and along a stable Phillips Curve (point A to point B). If actual inflation is lower than expected inflation (2% instead of 4%), then unemployment increases, movement down along the PC (Point A to point C).

Expected Inflation & Actual Inflation Long-run Phillips Curve Inflation Rate Actual Rate of Inflation B 6 % Expected Rate of Inflation 4 % A C 2 % Natural Rate of Unemployment/NAIRU Unemployment Rate

Expectations and the SRPC in the Long-Run In the long run, expected inflation adjusts to changes in actual inflation. --This is shown by a shift of the short-run Phillips Curve --If inflationary expectations are now higher the curve shifts right (PC1 to PC2). --If inflationary expectations are now lower the curve shifts left (PC2 to PC1).

How Expected Inflation Shifts the Short-Run Phillips Curve... 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 2. …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B 1. Expansionary policy moves the economy up along the short-run Phillips curve... SRPC 2 A SRPC1 Natural rate of unemployment/NAIRU Unemployment Rate

Deflation Deflation-prices drop as a result of a deep recession Zero Bound-What would happen if the expected rate of inflation is -2% and the current interest rate is 0%? Liquidity Trap Why is deflation a problem? And why is it hard to end?   A. Debt Deflation Note: ask the students who would dislike deflation? Wouldn’t everyone love a falling aggregate price level? Maybe not. Due to the falling price level, a dollar in the future has a higher real value than a dollar today. So lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises. What do you expect borrowers to do? Cut back on spending. So weak spending causes deflation, which causes less spending, which causes deflation…. B. Effects of Expected Deflation We have already seen that interest rates are affected by inflation expectations. What about deflation? Nominal rate = real rate + expected inflation Suppose the rr=2% and expected inflation = 3%, then the nominal rate = 5%. But what if there is prolonged deflation and expected inflation is -2%, the nominal rate is 0%. Interest rates cannot fall below 0%, there is a zero bound. So deflation creates a situation where lenders receive nominal interest rates that approach zero. Lending will stop. If the economy is extremely depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective. The Fed can’t lower the interest rate lower than 0%!! This kind of deflation can cause an economy to languish for a very long time. This is referred to as the liquidity trap.