Unit 3: Aggregate Demand and Supply and Fiscal Policy 1

The Phillips Curve The tradeoff between inflation and unemployment. What happens to inflation and unemployment when AD increase?

In general, there is an inverse relationship between unemployment and inflation 3

Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation When there is a recession, unemployment is high but inflation is low 5% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC 2% 9% Unemployment 4

Short Run Phillips Curve What happens when AS falls causing stagflation? Increase in unemployment and inflation Inflation 5% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment SRPC1 1% SRPC 2% 9% Unemployment 5

Short Run vs. Long Run What happens when AD increases? What happens in the long run? Long Run Phillips Curve Inflation In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment SRPC1 1% SRPC 2% 5% 9% Unemployment 6

Short Run vs. Long Run Long Run Phillips Curve In the long run there is no tradeoff between inflation and unemployment Long Run Phillips Curve Inflation 5% The LRPC is vertical at the Natural Rate of Unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9% Unemployment 7

What happens when AD falls? What happens in the long run? Short Run vs. Long Run What happens when AD falls? What happens in the long run? Long Run Phillips Curve Inflation 5% In the long run wages fall and there is no tradeoff between inflation and unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC SRPC1 2% 5% 9% Unemployment 8

AD/AS and the Phillips Curve

Progression of the Phillips Curve 1958, A.W. Phillips studied the relationship of wages and unemployment 1960’s - unemployment was high and inflation was low. 1970’s - high inflation and high unemployment Milton Friedman and Edmund Phelps say there “two” Phillips Curve One Short Run Curve and One Long Run Curve

SRAS LRPC LRAS Price Level Inflation SRPC QY GDPR UY Unemployment 11

AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPR UY Unemployment 12

SRAS LRPC LRAS Price Level Inflation PLe AD2 AD SRPC AD3 QY GDPR UY Unemployment 13

AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPC QY GDPR UY Unemployment 14

AD/AS and the Phillips Curve Show what happens on both graphs if AD increase LRPC Price Level LRAS Inflation AS PLe AD1 AD SRPC QY GDPR UY Unemployment 15

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls? Price Level LRAS LRPC Inflation AS PLe AD SRPC AD1 QY GDPR UY Unemployment 16

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when AS falls? Price Level LRAS LRPC Inflation AS1 AS PLe SRPC1 AD SRPC QY GDPR UY Unemployment 17

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up? Price Level LRAS LRPC Inflation AS AS1 PLe SRPC AD SRPC1 QY GDPR UY Unemployment 18

2008 Practice FRQ 19

2008 Practice FRQ 20

Assume that a country’s economy is experiencing significant demand pull inflation. A.)Draw a correctly labeled graph of aggregate demand and aggregate supply showing the following: I.)Price level and output. II.)Full employment output B.) How demand pull inflation affect the Phillips Curve? C.)Identify a fiscal policy that will return the economy to full employment output and show the change on the graph in part (A) D.)This country decides to make a large investment in education and assume this country makes two goods (X and Y) draw a production possibilities curve showing effects of this policy change. E.) How is LRAS affected by the change in policy made in section D?