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 Phillips curve 0 (b) The Phillips Curve Inflation Rate (% per year) Unemployment Rate (%) 0 (a) The Model of AD and AS Price Level Low AD High AD B 4 6 A 7 2 A 7, B 8, SRAS Output

Shifts in the Phillips Curve: The Role of Supply Shocks uThe short-run Phillips curve shifts because of shocks to aggregate supply. uA supply shock is an event that directly affects firms’ costs of production and thus their ability to produce. uAn increase in the price of oil increases production costs and forces employers to lay off workers. uThis is shown by a leftward shift of the AS curve and an upward shift of the Phillips curve (higher prices and higher unemployment) uA positive supply shock would move AS to the right and shift the Phillips curve downward- lower prices and lower unemployment

AS 2 1. An adverse shift in aggregate supply… An Adverse Shock to Aggregate Supply... Quantity of Output 0 Price Level P1P1 Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 (b) The Phillips Curve A Inflation Rate Phillips curve, PC 1 Aggregate supply, AS 1 A Y1Y1 P2P2 3. …and raises the price level… B 2. …lowers output… Y2Y2 B 4. …creating a less favorable tradeoff between unemployment and inflation. PC 2

How the Phillips Curve is Related to the Model of AD/AS in the Long-run An increase in the money supply increases the aggregate demand. This raises the price level (AD/AS model) and the inflation rate (Phillips curve). But leaves output and unemployment at their natural rates. Changes in price levels move up or down a vertical LRAS and LRPC, but do not affect the natural rate of output or employment.

Natural rate of unemployment Long-run Phillips curve 0 (b) The Phillips Curve Inflation Rate A Natural rate of output 0 P1P1 Aggregate demand, AD 1 Long-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level 4. …but leaves output and unemployment at their natural rates. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply in the long run P2P2 2. …raises the price level… Quantity of Output Unemploy- ment Rate 1. An increase in the money supply increases aggregate demand… AD 2 B 3. …and increases the inflation rate… Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

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... Unemployment Rate 0 Natural rate of unemployment Inflation Rate LRPC 1 LRPC 2

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 Unemployment Rate 0 Inflation Rate Long-run Phillips Curve A C B Natural Rate of Unemployment Expected Rate of Inflation 6 % 4 %

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 Unemployment Rate 0 Inflation Rate Long-run Phillips Curve A C B Natural Rate of Unemployment Actual Rate of Inflation Expected Rate of Inflation 6 % 4 %

Expectations and the Short-Run Phillips Curve u 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 trade- off between inflation and unemployment. --If inflationary expectations are now lower the curve shifts left. This is an improvement in the trade-off.

How Expected Inflation Shifts the Short-Run Phillips Curve... Unemployment Rate 0 Natural rate of unemployment Inflation Rate C B Long-run Phillips curve A Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short- run Phillips curve …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.