The Phillips Curve The Phillips Curve

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

0 PL 1 Y1Y1Y1Y1 AD 1 SRAS 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 AD 1 to AD 4 ? Price Level Real domestic output

o PL 1 PL 2 Y1Y1Y1Y1 Y2Y2Y2Y2 AD 1 AD 2 SRAS Price Level Real domestic output

o PL 1 PL 2 PL 3 Y1Y1Y1Y1 Y2Y2Y2Y2 Y3Y3Y3Y3 AD 1 AD 2 AD 3 SRAS Price Level Real domestic output

o PL 1 PL 2 PL 3 PL 4 Y1Y1Y1Y1 Y2Y2Y2Y2 Y3Y3Y3Y3 Y4Y4Y4Y4 AD 1 AD 2 AD 3 AD 4 SRAS Real domestic output Assuming a constant SRAS curve, we see that high inflation is accompanied by low unemployment.

Annual rate of inflation Unemployment rate (percent) We can demonstrate this short run trade off between inflation and unemployment by using the Phillips Curve. using the Phillips Curve. SRPC

Annual rate of inflation Unemployment rate (percent) Phillips Curve – there is an inverse relationship between inflation and unemployment. As inflation decreases, unemployment increases.

UNEMPLOYMENT RATE INFLATION RATE REAL OUTPUT PRICE LEVEL B C AD 1 AD 2 A AD 3 Phillips curve C B A SRAS SRPC The short-run Phillips Curve is an inverse of the SRAS curve. A rightward shift of AD moves up the SRAS curve; which also moves up the SRPC. AS/AD

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

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

UNEMPLOYMENT RATE INFLATION RATE REAL OUTPUT PRICE LEVEL B AD 1 A B A SRAS1 SRPC1 A leftward shift of AS, causing stagflation, equals a rightward shift of the SRPC. Phillips curve AS/AD SRAS2SRPC2

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.

UNEMPLOYMENT RATE INFLATION RATE REAL OUTPUT PRICE LEVEL B AD 1 A AD 2 Phillips curve B A SRAS1SRPC1 Increasing AD beyond FE may temporarily increase GDP/Y/employ.AS/AD LRAS LRPC FE NRU

UNEMPLOYMENT RATE INFLATION RATE REAL OUTPUT PRICE LEVEL B AD 1 A AD 2 Phillips curve B A SRAS1 SRPC1 But when nominal wages eventually catch up profits will fall, ending the stimulus to produce beyond FE.AS/AD LRAS LRPC FE NRU SRAS2 C SRPC2 C

SRPC3SRPC3SRPC3SRPC3 SRPC1SRPC1SRPC1SRPC1 SRPC2SRPC2SRPC2SRPC2 0 2 % 3 % 5 % 8 % 12 % 8 % 4 % b1b1b1b1 b2b2b2b2 b3b3b3b3 C1C1C1C1 c2c2c2c2 c3c3c3c3 LRPC Inflat.GapRecess.Gap 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 (5%). Unemployment Inflation

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