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Inflation and Unemployment and the Phillips Curve
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Short Run Phillips Curve
A. Inverse relationship between inflation and unemployment 1. Low unemployment leads to rising wages which leads to inflation 2. high unemployment leads to falling wages which keeps inflation low
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Inflation and Unemployment and The Phillips Curve
On your handout create a graph like the one below that will be used for a Phillips Curve exercise. ALSO, create an AD/AS model in long run equilibrium Price Level LRAS 5 Inflation Rate SRAS 4 3 PLe 2 1 AD Real GDP -1 2 3 4 5 6 Unemployment Rate
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In the past the economy of Narvaizville has had 0% inflation
Suppose: In the past the economy of Narvaizville has had 0% inflation The people of Narvaizville expect 0% inflation Draw SRPC0 using the following information At 0% inflation there will be 6% unemployment At 2% inflation there will be 4% unemployment Price Level LRAS 5 Inflation Rate SRAS 4 3 PLe 2 1 AD Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville has 0% inflation. . .
Mark point A on the graph to show where the economy currently is. At point A actual inflation = expected inflation Price Level LRAS 5 Inflation Rate SRAS 4 3 PLe 2 1 A AD Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Suppose that the government of Narvaizville:
considers 6% unemployment is too high They pursue fiscal policy to bring unemployment down to 4% Increase Government spending AD shifts right LRAS 5 Price Level Inflation Rate SRAS 4 3 PLe 2 1 A AD Ye Y1 Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Suppose that the government of Narvaizville:
considers 6% unemployment is too high They pursue fiscal policy to bring unemployment down to 4% Increase Government spending AD shifts right Move along SRPC to 4% unemployment – we are now at B Inflation is now at 2% LRAS 5 Price Level Inflation Rate SRAS 4 PL1 3 B PLe 2 AD1 1 A AD Ye Y1 Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville now has 2% inflation . . .
the people will EXPECT 2% inflation Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left LRAS 5 Price Level Inflation Rate SRAS 4 PL1 3 B PLe 2 AD1 1 A AD Ye Y1 Real GDP SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville now has 2% inflation . . .
the people will EXPECT 2% inflation Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left Price Level LRAS SRAS1 5 Inflation Rate SRAS PLe 4 3 B 2 AD1 1 A AD Ye Real GDP SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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SRAS shifts left = SRPC shifts right
Narvaizville now has 2% inflation . . . the people will EXPECT 2% inflation Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left SRAS shifts left = SRPC shifts right Draw a new SRPC to show this shift. Label it SRPC2 Price Level LRAS SRAS1 5 Inflation Rate SRAS 4 PLe 3 B 2 AD1 1 A AD Ye Real GDP SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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The economy maintains 2% inflation we are now at point C
Narvaizville now has 2% inflation . . . the people will EXPECT 2% inflation Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left SRAS shifts left = SRPC shifts right Draw a new SRPC to show this shift. Label it SRPC2 The economy maintains 2% inflation we are now at point C LRAS Price Level SRAS1 5 Inflation Rate SRAS 4 PLe 3 B C 2 AD1 1 A AD Y1 Ye Real GDP SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville’s unemployment rate is now 6%
The government still considers 6% unemployment too high They once again use fiscal policy to bring unemployment down to 4% Increase government spending AD shifts right LRAS SRAS1 Price Level 5 Inflation Rate PLe SRAS 4 3 B C 2 AD1 1 A AD Ye Y1 Real GDP SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville’s unemployment rate is now 6%
The government still considers 6% unemployment too high They once again use fiscal policy to bring unemployment down to 4% Increase government spending AD shifts right LRAS Price Level SRAS1 5 Inflation Rate PL1 SRAS 4 PLe 3 B C AD2 2 AD1 1 A AD Ye SRPC2 Y1 Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville’s unemployment rate is now 6%
The government still considers 6% unemployment too high They once again use fiscal policy to bring unemployment down to 4% Increase government spending AD shifts right Move along SRPC to 4% unemployment – we are now at D LRAS Price Level SRAS1 5 Inflation Rate PL1 D SRAS 4 PLe 3 B C 2 AD2 AD1 1 A AD Ye Y1 Real GDP SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville now has 4% inflation . . .
the people will EXPECT a 4% inflation rate. Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left LRAS Price Level SRAS1 5 Inflation Rate PL1 D SRAS 4 PLe 3 B C 2 AD2 AD1 1 A SRPC4 AD Ye Real GDP SRPC2 Y1 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Narvaizville now has 4% inflation . . .
the people will EXPECT a 4% inflation rate. Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left LRAS SRAS2 Price Level SRAS1 PLe 5 Inflation Rate D SRAS 4 3 B C 2 AD2 AD1 1 A SRPC4 AD Ye SRPC2 Y1 Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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SRAS shifts left = SRPC shifts right
Narvaizville now has 4% inflation . . . the people will EXPECT a 4% inflation rate. Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left SRAS shifts left = SRPC shifts right Draw a new SRPC to show this shift. Label it SRPC4 LRAS SRAS2 Price Level SRAS1 PLe 5 Inflation Rate D SRAS 4 3 B C 2 AD2 AD1 1 A SRPC4 AD Ye SRPC2 Y1 Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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The economy will maintain 4% inflation We are now at point E
Narvaizville now has 4% inflation . . . the people will EXPECT a 4% inflation rate. Workers will ask for a raise to maintain purchasing power Higher wages = higher input costs = SRAS shifts left SRAS shifts left = SRPC shifts right Draw a new SRPC to show this shift. Label it SRPC4 The economy will maintain 4% inflation We are now at point E LRAS SRAS2 Price Level SRAS1 PLe 5 Inflation Rate D E SRAS 4 3 B C 2 AD2 AD1 1 A SRPC4 AD Ye SRPC2 Y1 Real GDP -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Draw a line connecting the points where
actual inflation = expected inflation This is Long Run Phillips Curve and it is at the natural rate of unemployment LRPC 5 Inflation Rate D E 4 3 B C 2 1 A SRPC4 SRPC2 -1 SRPC0 2 3 4 5 6 Unemployment Rate
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Long Run Phillips Curve
A in the long run there is no trade off between unemployment and inflation B. People’s wages eventually adjust to the gap between inflationary expectations and the actual rate of inflation. C. LRPC is where EXPECTED inflation is equal to ACTUAL inflation D. Any rate of inflation is consistent with the natural rate of unemployment
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III. Relationship between AD/AS and the Phillips curve
A. Shift in AD causes movement along Phillips curve. 1. Increase in AD = leftward movement along SRPC a. Price increase = inflation increase b. Output increase = lower unemployment Price Level inflation LRAS LRPC SRAS B B PL1 A PLe A AD1 AD SRPC Ye Y1 Real GDP unemployment
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2. decrease in AD = rightward movement along SRPC
a. Price decrease = inflation decrease b. Output decrease = higher unemployment Price Level inflation LRAS LRPC SRAS A PLe A B PL1 B AD SRPC AD1 Y1 Ye Real GDP unemployment
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B. Shift in SRAS causes shift in Phillips curve.
1. decrease in SRAS = rightward shift in SRPC a. Price increase = inflation increase b. Output decrease = higher unemployment Price Level inflation LRAS LRPC SRAS1 SRAS B B PL1 A PLe A SRPC1 AD SRPC Y1 Ye Real GDP unemployment
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2. increase in SRAS = leftward shift in SRPC
a. Price decrease = inflation decrease b. Output increase = lower unemployment Price Level inflation LRAS LRPC SRAS SRAS1 A PLe A B PL1 B AD SRPC SRPC1 Ye Y1 Real GDP unemployment
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IV. Expectations 1. changes in the expected rate of inflation affect the Short Run Phillips Curve 2. If prices are expected to rise a. Workers will ask for higher wages so they can keep their purchasing power b. Increase in wages = increase in the cost of an input c. SRAS shifts left = SRPC shift right 3. expected inflation = actual inflation = SRPC shifts to the right.
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