Intro to the Phillips Curve AP Macroeconomics

Where did we come from? The last lesson continued to examine the interaction between monetary & fiscal policy, and the impact of monetary policy on the following:  Price level  Output  Unemployment  Interest rates  Investment

Where are we going? In this lesson, we’ll take a look at the relationship between inflation and unemployment, and introduce something called the Phillips Curve.

Phillips what? The Phillips Curve is an empirical relationship founded by A.W. Phillips that shows the relationship between the unemployment rate and the rate at which wages change. He discovered that changes in wages were inversely related to the unemployment rate. Research since established the same relationship between inflation and unemployment.

“…at any given point in time, there is a trade-off between unemployment and inflation.” (Krugman, 335)

Short-Run Phillips Curve AD and SRAS and Short Run Phillips Curve Unit 5: Macroeconomics Visual 5.4 Point A is the expected inflation rate – natural unemployment rate point If there is an unanticipated increase in AD, unemployment decreases and inflation increases: a movement to Point A2 (and vice versa).

Remind me… Frictional unemployment is the time that you spend looking for a job or between jobs. Structural unemployment occurs when there is a mismatch between skills demanded in the labor market and the actual skills people seeking jobs possess. “Natural unemployment is the lowest level of unemployment at which inflation remains stable.” (

FYI Expectations about inflation increase or decrease actual inflation. That is, if people expect an increase in inflation, they will demand higher wages. Higher wages increase the actual price level, thus increasing inflation. “Workers and employers build the expectation into wages and prices.” (Krugman, 334)

Unit 5: Macroeconomics Visual 5.4 AD and SRAS and Short Run Phillips Curve We can also explain this using our AD/AS model. Let’s say that AD & AS intersect at full employment. Let’s say we are below the natural level of unemployment/inflation. Suppose that AD is expected to increase. AD shifts to AD1. The wage rate rises because of the anticipated increase in prices: people want to maintain their real wage. Increase in nominal wage shifts SRAS to SRAS1 (we know this is a determinant for AS). Thus, we are at Point A in both the Phillips Curve graph and AD & AS graph! (it brings us back to natural level of inflation/unemployment)

Unit 5: Macroeconomics Visual 5.4 AD and SRAS and Short Run Phillips Curve Now let’s say that AD shifts again. People thought it would move to AD1 but instead it moves to AD2. In both graphs, it moves to Point A2. At this point, inflation is above the expected rate of inflation, and unemployment is below the natural rate (or employment is above the natural rate).

What does this mean? If policy makers attempt to keep the unemployment rate at the level associated with A2, people will come to expect the inflation rate associated with A2. As a result, the SRPC will shift upward and/or outward until the inflation rate associated with A2 is at the natural rate of unemployment (that is, the unemployment rate will increase until the inflation rate at A2 in a sense becomes Point A). Unit 5: Macroeconomics Visual 5.4

Summary, please? To be continued… If you’re really that curious…  The short-run Phillips curve was drawn given an expected rate of inflation and a specific natural unemployment rate.  The SPRC will shift rightward if the expected inflation rate increases (this occurred in the 1970s).  The SPRC will shift leftward if the natural rate of unemployment decreases.

And now… Some resources: Reffonomics: Morton workbook: Krugman Module 34 pp

Works Cited Economics of Seinfeld. Krugman, Paul, and Robin Wells. Krugman’s Economics for AP. New York: Worth Publishers. Morton, John S. and Rae Jean B. Goodman. Advanced Placement Economics: Teacher Resource Manual. 3 rd ed. New York: National Council on Economic Education, Print. Reffonomics.