Phillips Curve

1
Phillips Curve

• Deriving the Phillips Curve from AD/AS
• Derive the Short and Long Run Phillips Curves
• What shifts the SRPC and the LRPC
• Short AND Long Term Effects of INFLATION on the
  Phillips Curve

2
Phillips Curve
LRAS
SRAS
.
Price Level
Inflation
.
.
B
PL1
A
PL
AD1
C
PL2
AD
AD
SRPC
FE
RDP2
Unemployment
RGDP1
Real GDP
RGDP
The Short-Run Phillips Curve illustrates the
Trade-off between Inflation and Unemployment
(derived from what is happening to RGDP) that
occurs as the AD curve traverses (either up or
down) the UPWARD sloping (Intermediate) range of
SRAS.
3
Phillips Curve
LRAS
SRAS
.
Price Level
Inflation
.
.
B
PL1
A
PL
AD1
C
PL2
AD
AD
SRPC
FE
RDP2
Unemployment
RGDP1
Real GDP
RGDP
IMPORTANT---Movement ALONG the SRPC corresponds
with AD movement ALONG the Upward Sloping
(Intermediate Range) of the SRAS Curve. The
Phillips Curve is important because for A long
timepost WWIIFiscal Policy (FP) and Monetary
Policy (MP)was driven by this relationship
between inflation and unemployment
4
Phillips Curve
5
Phillips Curve
LRAS
SRAS
.
Price Level
Inflation
.
.
B
PL1
A
PL
AD1
C
PL2
AD
AD
SRPC
FE
RDP2
Unemployment
RGDP1
Real GDP
RGDP
If Unemployment was the problem then policy
makers (FP and MP) INCREASED AD to DECREASE
unemployment, but this tended to create
INFLATION.
6
Phillips Curve
LRAS
SRAS
.
Price Level
Inflation
.
.
B
PL1
A
PL
AD1
C
PL2
AD
AD
SRPC
FE
RDP2
Unemployment
RGDP1
Real GDP
RGDP
OrIf Inflation was the problem then policy
makers (FP and MP) DECREASED AD to DECREASE
Inflation, but this tended to create
Unemployment.tackling the evil of the Day
tended to make the other evil worse
7
Phillips Curve
LRAS
SRAS
.
.
Price Level
Inflation
.
.
B
PL1
A
PL
AD1
C
PL2
AD
AD
SRPC
FE
RDP2
Unemployment
RGDP1
Real GDP
RGDP
Lets look at Point A on the SRPC---Notice it
corresponds with the PL and FE GDP Which also
represents the economy at is normal Long Run
Equilibrium StateRemember-LRAS represents
POTENTIAL, LONG TERM RGDP. At FE RGDP the
unemployment rate is the Natural Rate of
Unemployment. In the LONG RUN no matter how much
AD increases will ALWAYS Come up against the
wall of LRAS NO MATTER WHAT THE PRICE LEVEL
IS!!
8
Phillips Curve
LRAS
SRAS
.
.
Price Level
Inflation
.
.
B
PL1
A
PL
AD1
C
PL2
AD
AD
SRPC
FE
RDP2
Unemployment
RGDP1
Real GDP
RGDP
Soif in the LONG RUN the Unemployment Rate stays
at the Natural Rate of Unemployment REGARDLESS
of the PRICE LEVEL, what to you think the LONG
RUN PHILLIPS CURVE is going To look like??
9
Phillips Curve
.
LRPC
10
.
Inflation
.
B
A
C
SRPC
0
NRU
10
(5)
Unemployment
The LONG RUN PHILLIPS CURVE (LRPC) is VERTICAL
at the Natural Rate of Unemployment!! NO MATTER
WHAT THE INFLATION RATE IS THE NRU STAYS THE
SAME..
10
Phillips Curve
LRAS
SRAS
LRPC
.
Price Level
Inflation
.
.
.
B
A
B
p
PL
C
AD
SRPC
NRU
FE
Unemployment
RGDP
Real GDP
IMPORTANT Point A on the Phillips Curve
represents the LONG RUN situation where
INFLATION Is going to be stable at NRU (roughly
5) AND Point B on the AD/AS graph represents
the LONG RUN situation where AD SRAS LRAS
(Long Run Equilibrium). Embedded in the concept
of FE RGDP is the Unemployment rate is at its
Natural Rate (roughly 5).
11
Phillips Curve
LRAS
SRAS
LRPC
.
Price Level
Inflation
.
.
B
A
B
A
p
PL
C
AD
SRPC
NRU
FE
Unemployment
RGDP
Real GDP
IMPORTANT The Long Run Phillips Curve is NOT
the same thing as the LRAS!!! The ONLY thing
They have in common is (LRPC Explicitly and
LRAS Implicitly) is the Natural Rate of
Unemployment. The LRAS can shift without causing
the NRU to change AND/OR the LRPC can shift
without the LRAS curve shifting.GOT THAT?
12
What SHIFTS the SRPC and the LRPC?

• The SRPC and LRPC are not static, they can shift
  left or right.
• SRPC is MARRIED to the SRAS curve on our AD/AS
  Model of the Economy
• WHATEVER shifts the SRAS curve causes the SRPC to
  shift as well.
• However they shift in OPPOSITE directions!!!

13
Phillips Curve
LRAS
SRAS
SRAS1
Price Level
Inflation
.
PL1
A
p
PL
AD
SRPC
NRU
FE
RGDP1
Real GDP
Unemployment
RGDP
IMPORTANT Lets assume the Economy experiences a
NEGATIVE Supply ShockWe know this is going to
cause the SRAS curve to shift to the LEFT
(STAGFLATION)
14
Phillips Curve
LRAS
SRAS
SRAS1
.
Price Level
Inflation
.
PL1
A
p
PL
SRPC1
AD
SRPC
NRU
FE
RGDP1
Real GDP
Unemployment
RGDP
Look at our new equilibrium point on the AD/AS
graph (red dot). At this new equilibrium point
If AD increased or decreased it would do so at
an inflation rate HIGHER relative to the
previous Equilibrium point at ANY point on the
new SRAS curve. On the Phillips Curve graph NOW
at any unemployment rate the inflation rate is
going to be HIGHER relative to SRPC The SHORT
RUN PHILLIPS CURVE shifts to the RIGHT!! Hint
SRAS shifts LEFT, SRPC shifts RIGHT.
15
Phillips Curve
LRAS
SRAS
SRAS1
.
Price Level
Inflation
.
PL1
A
p
PL
SRPC1
AD
SRPC
NRU
FE
RGDP1
Real GDP
Unemployment
RGDP
Look at our new equilibrium point on the AD/AS
graph (red dot). At this new equilibrium point
If AD increased or decreased it would do so at
an inflation rate HIGHER relative to the
previous Equilibrium point at ANY point on the
new SRAS curve. On the Phillips Curve graph NOW
at any unemployment rate the inflation rate is
going to be HIGHER relative to SRPC The SHORT
RUN PHILLIPS CURVE shifts to the RIGHT!! Hint
SRAS shifts LEFT, SRPC shifts RIGHT.
16
Short Run Phillips Curve

• What do you think is going to happen to the SRPC
  in the event of a POSITIVE SUPPLY SHOCK???
• SRAS curve shifts to the RIGHT and SRPC shifts to
  the LEFT!!!!

17
Phillips Curve

• IMPORTANT Whenever causes the short run AS
  curve to shift INDEPENDENT of the LRAS curve is
  going to cause the Phillips Curve to shift as
  well.
• SRAS shifts RIGHT (positive supply shock) then
  the SRPC is going to shift to the LEFT
• SRAS shifts LEFT (negative supply shock) then the
  SRPC is going to shift to the RIGHT.

18
LONG RUN PHILLIPS CURVE

• What shifts the LONG RUN PHILLIPS CURVE?
• Changes in government benefits to the
  unemployed/underemployed
• Changes in the composition of the Labor force
• Changes in Supply-Side policies

19
Phillips Curve
LRPC
LRPC1
10
Inflation
SRPC
0
NRU1 (7)
NRU
10
(5)
Unemployment
Changes in Govt Benefits towards the UNEMPLOYED
and the UNDEREMPLOYED If the Govt. INCREASES the
benefits they pay to the unemployed/underemployed
in general this produces a higher level of
FRICTIONAL unemployment. People tend to
stay Unemployed for longer periods of time
because the replacement income they receive from
the govt. is closer to their lost incomeIn
other words, the incentive to look for a Job is
diminished and the tendency to stay unemployed
increases.. The LONG RUN PHILLIPS CURVE SHIFTS TO
THE RIGHT
20
Phillips Curve
LRPC
LRPC1
10
Inflation
SRPC
0
NRU1 (3)
NRU
10
(5)
Unemployment
Changes in Govt Benefits towards the UNEMPLOYED
and the UNDEREMPLOYED If the Govt. DECREASES the
benefits they pay to the unemployed/underemployed
in general this produces a lower level of
FRICTIONAL unemployment. People tend to
stay Unemployed for shorter periods of time
because the replacement income they receive from
the govt. is much LESS then their original
incomeIn other words, the incentive to look for
a job is INCREASES and the tendency to stay
unemployed DECREASES... The LONG RUN PHILLIPS
CURVE SHIFTS TO THE LEFT
21
Frequency Frequency Annual Annual Annual Quarterly Quarterly Quarterly
Time Time 2004 2005 2006 2006 2006 2007
Time Time 2004 2005 2006 Q3-2006 Q4-2006 Q1-2007
Country
Australia i 5.5 5.1 4.9 4.8 4.6 4.5
Austria i 4.8 5.2 4.8 4.7 4.5 4.5
Belgium i 8.4 8.4 8.2 8.1 7.9 7.7
Canada i 7.2 6.8 6.3 6.4 6.2 6.1
Czech Republic i 8.3 7.9 7.2 7.1 6.6 6.3
Denmark i 5.5 4.8 3.9 3.7 3.6 3.4
Finland i 8.9 8.4 7.7 7.8 7.4 6.9
France i 9.6 9.7 9.4 9.3 9.1 8.8
Germany i 9.5 9.4 8.4 8.4 7.9 7.2
Greece i 10.5 9.9 8.9 8.7 8.6 ..
Hungary i 6.1 7.2 7.5 7.6 7.7 8
Ireland i 4.5 4.3 4.4 4.4 4.2 4
Italy i 8 7.7 6.8 6.6 6.5 ..
Japan i 4.7 4.4 4.1 4.1 4.1 4
Korea i 3.7 3.7 3.5 3.4 3.4 3.2
Luxembourg i 5.1 4.5 4.8 4.7 4.8 4.9
Netherlands i 4.6 4.7 3.9 3.9 3.7 3.5
New Zealand i 3.9 3.7 3.8 3.8 3.7 3.8
Norway i 4.4 4.6 3.5 3.3 2.9 2.7
Poland i 19 17.7 13.8 13.4 12.6 11.8
Portugal i 6.7 7.6 7.7 7.6 8 8.1
Slovak Republic i 18.2 16.2 13.4 13.1 12.4 11.1
Spain i 10.6 9.2 8.5 8.3 8.4 8.2
Sweden i 6.3 7.3 7 6.9 6.5 6.5
Switzerland i 4.4 4.5 4 3.9 3.8 3.7
United Kingdom i 4.7 4.8 5.3 5.4 5.4 ..
22
Why do some other major economies have
persistently higher unemployment rates than the
U.S.

• Government policies are a major culprit

23
Phillips Curve and The short and long terms
effects of inflaton.

• We will use as an example a sub-topic from the 1
  FRQ from the 2009 AP Macroeconomics Test

24
LRAS
Price Level
SRAS
LRPC
INFLATION
PL
AD
6
RGDP
RGDP
SRPC
NRU
UNEMPLOYMENT
The INFLATION RATE currently is 6 and the
Federal Reserve believes that is too HIGH. They
decide to target 3 as a preferred level of
Inflation.
25
Price Level
SRAS
LRPC
INFLATION
PL
AD
6
RGDP
RGDP
SRPC
NRU
UNEMPLOYMENT
In order to DECREASE INFLATION the Federal
Reserve would carry out the Open Market
Operation or SELLING BONDS---this will DECREASE
the Money Supply and INCREASE the FEDERAL FUNDS
RATE and tend to INCREASE INTEREST RATES
throughout the Financial System.
26
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
SRPC
NRU
UNEMPLOYMENT
INCREASING INTEREST RATES will cause AD to
DECREASE
27
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
SRPC
NRU
UNEMPLOYMENT
REAL GDP will DECREASE AND PRICE LEVEL
(inflation) will DECREASE AND Because RGDP
DECREASES, UNEMPLOYMENT will INCREASE
28
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
INFLATION is DECREASING and UMEPLOYMENT IS
INCREASING---There is MOVEMENT ALONG THE
PHILLIPS CURVE IN THE SHORT RUN
29
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
The Economy settles at a LOWER INFLATION RATE and
a HIGHER UNEMPLOYMENT RATE
30
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
NOTE This is the situation in the
SHORT-RUN---What is the LONG-TERM EFFECT of
the Federal Reserves action?
31
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
People (and business and govt) EXPECTIONS about
INFLATION are now going to Be built-in---They
have expectations of LOWER PRICES AND WAGES.
32
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
This will affect a number of things BUT lets
focus on WAGES
33
Price Level
SRAS
LRPC
INFLATION
PL
PL1
AD
6
AD1
RGDP
RGDP1
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
Because there are expectations of LOWER Inflation
then WAGES tend to Stabilize and MAY decrease
(assume this to be the case)On the AD/AS Graph,
which curve is going to be affected???
34
SRAS
Price Level
SRAS1
LRPC
INFLATION
PL
PL1
AD
PL2
6
AD1
RGDP
RGDP1
RGDP2
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
Aggregate Supply!! Cost of Production will tend
to DECREASEWhen C.O.P DECREASES then Aggregate
Supply will INCREASE (Shift to the Right)
35
SRAS
Price Level
SRAS1
LRPC
INFLATION
PL
PL1
AD
PL2
6
AD1
RGDP
RGDP1
RGDP2
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
Price Level (inflation) has DECREASED and RGDP
has INCREASED (back to the original FE FGDP
therefore UNEMPLOYMENT has DECREASED.
36
SRAS
Price Level
SRAS1
LRPC
INFLATION
PL
PL1
AD
PL2
6
AD1
RGDP
RGDP1
RGDP2
RGDP
3
SRPC
NRU
UR1
UNEMPLOYMENT
How does this affect the Phillips Curve??? When
the SRAS curve shifts to the RIGHT The Short-Run
Phillips Curve shifts to the LEFT!! Now at every
level of UNEMPLOYMENT the PRICE LEVEL will be
LOWER.
37
SRAS
Price Level
SRAS1
LRPC
INFLATION
PL
PL1
AD
PL2
6
AD1
RGDP
RGDP1
RGDP2
RGDP
3
Economy is BACK to FE where AD SRASLRAS We are
STILL at the NRU but at a LOWER I INFLATION RATE!!
SRPC
NRU
UR1
UNEMPLOYMENT
With the shift of The Short Run Phillips Curve we
move back to Long-Run Equilibrium where SRPC
intersect LRPC at the NRU.THE LONG RUN PHILLIPS
CURVE IS NOT GOING TO SHIFT.
38
The End