AP Macro
Phillips Curve, Monetary Policy
The Phillips Curve
(hypothetical example)
tt%
4%
2%
. .
.
. ..
5%
7%
.
PC
u%
Note: Inflation Expectations are held constant
The Phillips Curve
• In a 1958 paper, New Zealand born economist,
A.W. Phillips published the results of his research
on the historical relationship between the
unemployment rate (u%) and the rate of inflation
(tt%) in Great Britain.
• His research indicated a stable inverse
relationship between the u% and the tt%. As u%↓,
tt%↑ ; and as u%↑, tt%↓.
• The implication of this relationship was that policy
makers could exploit the trade-off and reduce u%
at the cost of increased tt%.
Trouble for the Phillips Curve
• In the 1970’s the U.S. experienced concurrent high
u% & tt%, = stagflation.
• 1976 American Nobel Prize economist Milton
Friedman saw stagflation as disproof of the stable
PC.
• Instead of a trade-off between u% & tt%,
Friedman and 2006 Nobel Prize recipient Edmund
Phelps believed that Un was independent of the
tt%. This independent relationship is now referred
to as the Long-Run Phillips Curve.
1970’s Phillips Curve
π%
4%
2%
.
. .
. ..
.
. . .
. ..
.
5%
7%
.
PC
u%
The Long-Run Phillips Curve
π%
LRPC
un %
u%
Note: Natural rate of unemployment is held constant
Un defined
The natural rate of unemployment (NRU) is defined as the equilibrium
rate of unemployment i.e. the rate of unemployment where real wages
have found their free market level
It is where the aggregate supply of labor is in balance with the
aggregate demand for labor.
At the natural rate, all those wanting to work at the prevailing real wage
rate have found employment and there is no involuntary unemployment
There remains some voluntary unemployment as some people remain
out of a job searching for work offering higher real wages or better
conditions.
The Long-Run Phillips Curve (LRPC)
• b/c the LRPC exists at the un, structural changes
in the economy that affect un will also cause the
LRPC to shift.
• In order to reduce the Un, structural policies
must be directed towards an economy's supply
side.
• Increases in un will shift LRPC 
• Decreases in un will shift LRPC 
Inflation
rate
LRPC
4%
2%
SRPC (assumes 4 % expected inflation at each UR)
SRPC (assumes 2% expected inflation at each UR)
Natural rate
of
unemployment
Unemployment
rate
Phillips Curve – LR and SR
Summary
• There is a short-run trade off between u% & π%. This is
referred to as a short-run Phillips Curve (SRPC)
• In the long-run, no trade-off exists between u% & π%. This
is referred to as the long-run Phillips Curve (LRPC)
• The LRPC exists at the natural rate of unemployment (un).
– un ↑ .: LRPC 
– un ↓ .: LRPC 
• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC
– AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
– AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC
• Δ Inflationary Expectations, Δ Input Prices, Δ Productivity,
Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC
– SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC 
– SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC 
Reconciling the LRPC and SRPC
LRPC
tt%
tt1 %
B 
A
tt %
In the short-run,
assuming the
policy is
successful,
inflation occurs
and
unemployment
decreases as
the economy
moves from A
to B.
C
In the long-run, the inflation
rate at B (π1 %)
becomes the new expected
inflation rate (π1^%), and the
economy returns to the
natural rate of unemployment
(point C).
SRPC (tt1^ %)
SRPC (tt^ %)
u%
u N%
u%
Assume that either
the government or
the central bank
enacts an
expansionary
policy to reduce
the
unemployment
rate below its
natural rate at
point A.
Reconciling the LRPC and SRPC
π%
π1 %
LRPC
A
C

π%
In the long-run, the inflation
rate at B (π1 %)
becomes the new expected
inflation rate (π1^%), and the
economy, once again,
returns to the natural rate of
unemployment (point C).
Now assume that
either the government
or the central bank
enacts a
B
SRPC (π^ %) Contractionary
SRPC (π1^ %)
In the short-run, assuming the
policy is successful, disinflation
occurs and unemployment
increases as the economy
moves from A to B.
u N%
u%
u%
policy to reduce
inflation from it’s
current rate at point A
Relating Phillips Curve to
AS/AD
• Changes in the AS/AD model can also be seen in
the Phillips Curves
• An easy way to understand how changes in the
AS/AD model affect the Phillips Curve is to think of
the two sets of graphs as mirror images.
• NOTE: The 2 models are not equivalent. The AS/AD
model is static, but the Phillips Curve includes
change over time. Whereas AS/AD shows one
time changes in the price-level as inflation or
deflation, The Phillips curve illustrates continuous
change in the price-level as either increased
inflation or disinflation.
Movements along the SRPC
Shifts of the SRPC
• Expected TT:
If TT goes up – shift up.
If TT goes down – shift down
• SRAS increases = shift SRPC right
• SRAS decreases = shift SRPC left
Shifts of the LRPC
Increase in AD = Up/left
movement along SRPC
PL
SRAS
SRPC

π1
π


P1
..
AD1
AD

Y
YF

P
.
.
LRAS
π%
GDPR
un
u
C↑, IG↑, G↑ and/or XN↑
.: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
u%
Decrease in AD = Down/right
along SRPC
LRAS
PL

P1
.
SRAS
SRPC
π

.

P
π%
.
.
π1
AD
AD1

YF
Y

GDPR
u
un
u%
C↓, IG↓, G↓ and/or XN↓
.: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC
SRAS  = SRPC 
PL
LRAS
.
P1
Y
YF
LRPC
π1
.
GDPR
un
π
AD

SRPC1


.
SRAS1

SRPC
.

P
π%

SRAS
u
u%
Inflationary Expectations↓, Input Prices↓, Productivity↑,
Business Taxes↓, and/or Deregulation
.: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC  (Disinflation)
SRAS  = SRPC 
SRAS1
SRAS
.


.
π1
π
AD

Y1
YF
LRPC
SRPC

P1
P
π%
LRAS

PL
SRPC1
.
.

GDPR
u n u1
u%
Inflationary Expectations↑, Input Prices↑, Productivity↓,
Business Taxes↑, and/or Increased Regulation
.: SRAS  .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC  (Stagflation)
Phillips Curve Review
• SRAS increases = shift SRPC right
• SRAS decreases = shift SRPC left
• AD increases = movement up and left
• AD decreases = movement down and right
• Increases in un will shift LRPC 
• Decreases in un will shift LRPC 
MS
NIR
•MS – affected by actions of the
Federal Reserve
i1
MD
Q1
•MD –
•Transaction demand
determined by GDP
•Asset demand
determined by NIR
Q
Money Market