The Phillips curve

1
The Phillips curve
It suggests we can trade-off more inflation
for less unemployment or vice versa.
2
Keynesian Solutions

• By selecting fiscal and monetary policy the
  government could determine level of AD and extend
  of involuntary unemployment
• AD??W,P??higher inflation???, unemployment??
• Governments choose a level of inflation and
  unemployment on the Philips curve
• high inflation- less unemployment
• high unemployment - less inflation
• to day we have both high unemployment and high
  inflation

3
The Phillips curve and an increase in aggregate
demand
Inflation
but what happens next?
PC0
Unemployment
4
initially

• In the long run M is fixed
• inflation ?0
• income Yp
• nominal interest rates R at their long-run eq.
  level
• Rr as there is no inflation

5
After a change in M

• Ones-and-for-all increase in M
• in the short run
• as P and W are sluggish
• mM/P?? R?? ADgtYp unemp??
• as P? ?gt0 or ?P/Pgt0
• this is the first step

6
In the medium run

• W,P ?? SAS shifts up slowly
• mM/P?? R?? AD?? unemp?? AD-Yp?
• an upward movement along MDS
• The change in P is proportional to the gab
  between AD and Yp
• W and P are raising at an ever slower rate
• ?P/P and ?W/W ?
• so ? decline
• the economy returned to long run eq
• there no pressure for W or P to change
• inflation is zero

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M
A once-and-for-all change in nominal money supply
time
Initial period
short run
medium run
long run
8
P
Change in prices
time
Initial period
short run
medium run
long run
?
Changes in inflation
time
9
AD
Change in output
Yp
Yp
time
Initial period
short run
medium run
long run
M
Changes in unemployment
U
U
time
10
Exercise

• Try to draw such adjustment paths for
• real money supply
• nominal interest rate
• Nominal wage rates

11
The Phillips curve and an increase in aggregate
demand
If nominal money supply is fixed in the long
run, and prices and wages eventually adjust,
the economy moves back to E.
Inflation
A
?1
E
U1
PC0
U
Unemployment
12
The Phillips curve and an increase in aggregate
demand
Inflation
But nominal money supply need not be constant in
the long run
A
?1
E
U1
PC0
U
Unemployment
13
Exercise

• What happens if there is a once-and-for-all
  reduction in money supply
• Describe the temporary trade off on a Philips
  Curve
• Draw the adjustment paths of variables as time
  progresses

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In conclusion(1)

• No permanent trade-off between inflation and
  unemployment
• Philips Curve show the temporary trade-off
• while the economy is adjusting to shock to AD
• following an upward shock to AD there is a
  temporary period of inflation

15
Conclusion (2)

• The speed with which the economy moves back
  along the PC depends on
• the degree of flexibility of W and P
• Monetarists believe that
• this flexibility is almost instantaneous
• if prices are sluggish
• it take much longer to adjust fully to a shock AD
  
• movements along PC to long run eq take much
  longer

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• The nominal money supply need not be constant in
  the long run
• suppose in long run eq
• ?M/M20 inflation 20 R22, r22-202
• ?W/W20, w(real wages) is constant
• m constant as ?P/P ?M/M
• output is at full eq Yp

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• In LR with no money illusion
• people care about real variables
• not nominal variables
• ?W/W20 ?M/M20 ?P/P20
• m,w not eroded by inflation
• Full employment,Yp, w real wages ( all real
  variables)will be unaffected by the inflation rate

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The vertical Phillips curve
Inflation
The short-run Phillips curve shows just a
short-run trade-off
A
E
?1 10
B
U1
PC0
U
Unemployment
19

• Suppose the economy is at E with a 10 long run
  inflation
• in the SR a boost in AD will take the economy to
  A
• In the short run
• W,P? ,m? ,AD?
• Inflation is temporarily above 10
• In the long run
• W,P?, m? AD?
• Inflation returns to 10
• economy returns to E along the PC1

20

• Starting a 10 inflation
• Suppose there is a once and for all change in M
• Draw the time paths of
• Price level
• Money supply
• Output
• Unemployment
• Nominal interest rates

21

• or any drop in AD
• take the economy to B
• unem ? ? P,W ?
• Show that the economy
• moves to E along PC1
• Describe the changes in real and nominal
  variables

22
Short run Philips Curve

• The SRPC describes the temporary trade-off
  between inflation and unemployment
• While the economy is adjusting to a change in AD
• The hight of the SRPC is determined by the hight
  of the point at which it cross the vertical LRPC
  rate of inflation in long run eq

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• As governments increases their money printing
  rates
• inflation accelerates
• long run eq inflation risen
• SRPC shifts upward along the LRPC
• There is a different SRPC for every long run
  inflation rate