1. Unit 3: Aggregate Demand and Supply and Fiscal Policy1

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

3. In general, there is an inverse relationship between unemployment and inflation3

4. 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

5. AD/AS and the Phillips Curve

6. 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

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

8. AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPRUY
Unemployment 12

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

10. AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPCQY
GDPR UY
Unemployment 14

11. 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

12. 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

13. 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

14. 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

15. 2008 Practice FRQ 19

16. 2008 Practice FRQ 20

17. 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 does 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?