The
Curve
The Phillips
Phillips Curve
• Demonstrates the short-run tradeoff between
inflation and unemployment
Concept
Empirical Data
7
6
5
4
3
2
1
0
0
1
2
3
4
5
6
Unemployment Rate (Percent)
LO3
7
Annual Rate of Inflation (Percent)
Annual Rate of Inflation (Percent)
Data for the 1960s
7
69
6
5
68
4
66
67
3
65
2
1
64
63
62
61
0
0
1
2
3
4
5
6
7
Unemployment Rate (Percent)
35-1
Inflation %
OR
THIS
Inflation %
The Phillips Curve
• In the short-run, this is correct.
• Typical short-run Phillips curve (SRPC) looks
like this:
SRPC
SRPC
Unemployment %
Unemployment %
What Questions Can We Answer Already?
A.
B.
C.
D.
Aggregate demand curve
Long-run Phillips curve
Short-run Phillips curve
Long-run aggregate supply
curve
E. Short-run aggregate supply
curve.
Inflation %
• Which of the following is depicted in the
graph below?
Unemployment %
What Questions Can We Answer Already?
Inflation %
• According to the short-run Phillips curve,
lower inflation rates are associated with…
SRPC
Unemployment %
What Questions Can We Answer Already?
Inflation %
• A short-run Phillips curve shows an inverse
relationship between…
SRPC
Unemployment %
What Questions Can We Answer Already?
Inflation %
• According to the short-run Phillips curve, a
decrease in unemployment is expected to be
accompanied by…
SRPC
Unemployment %
What Questions Can We Answer Already?
Inflation %
• According to the short-run Phillips curve,
there is a trade off between…
SRPC
Unemployment %
Price Level
LRAS
SRAS
PL1
PL2
AD
AD2
Y2
Y1
Real GDP
LRAS
Price Level
SRAS
PL2
PL1
AD2
AD
Y1
Y2
Real GDP
Period
Unemployment
Rate
2%
5%
This Year
Last Year
Inflation Rate
8%
4%
Inflation %
Draw a correctly labeled Phillips curve showing the actual
unemployment and inflation rates for both years. Label this
curve SRPC.
8
4
SRPC
2
5
Unemployment %
Assume the United States economy is operating at full-employment
output and the government has a balanced budget. A drop in consumer
confidence reduces consumption spending, causing the economy to
enter into a recession.
Inflation %
Using a correctly labeled graph of the short-run Phillips curve, show the
effect of the decrease in consumption spending. Label the initial
position “A” and the new position “B”.
A
B
SRPC
Unemployment %
Assume that a country’s government increases domestic military
expenditures.
Using a correctly labeled graph of the short-run Phillips curve, show the
effect of the increased military expenditures in the short run, labeling
the initial point as A and the new point as B.
Assume that a country’s government decreases personal income taxes.
(a) Using a correctly labeled graph of the short-run Phillips curve, show
the effect of the decreased personal income taxes in the short run,
labeling the initial point as A and the new point as B. (This one’s not on
the handout.)
In the long run, however, as we learned yesterday,
the unemployment rate will always return to natural
rate of unemployment, or full employment. So the
long-run Phillips curve looks like this:
Inflation %
LRPC
SRPC
Unemployment %
The natural rate of unemployment is consistent with ANY RATE
OF INFLATION in the LONG RUN!!!
So what can we say about the Long-run Phillips Curve?
Inflation %
LRPC
SRPC
Unemployment %
- It shows no trade-off between inflation and unemployment.
- It is vertical at the natural rate of unemployment.
How could we show an economy in long-run
equilibrium with a graph of both the long-run
and short-run Phillips curves?
Inflation %
LRPC
A
SRPC
Unemployment %
An economy is in short-run equilibrium at an output
level above full employment. Demonstrate this
using both a short-run and long-run Phillips curve.
Label the equilibrium point A.
LRPC
Inflation %
A
SRPC
Unemployment %
An economy is in short-run equilibrium at an output
level below full employment. Demonstrate this
using both a short-run and long-run Phillips curve.
Label the equilibrium point A.
Inflation %
LRPC
A
SRPC
Unemployment %
Changes in the inflation rate, in the long run, will
shift the SRPC so that the new inflation rate lies on
the Long-run Phillips Curve.
If inflation is lower, the SRPC will shift to the left.
Inflation %
LRPC
A
B
SRPC2
Unemployment %
SRPC
Changes in the inflation rate, in the long run, will shift the SRPC so that
the new inflation rate now lies on the Long-run Phillips Curve.
If inflation is higher, the SRPC will shift to the right.
It turns out that inflationary expectations are just as important in
shifting the SRPC. If workers and businesses expect inflation, they will
build it into wages, which will actually cause inflation.
LRPC
Inflation %
B
A
SRPC2
SRPC
Unemployment %
An economy is in short-run equilibrium at an output
level below full employment. Demonstrate this
using both a short-run and long-run Phillips curve.
Label the equilibrium point A.
Inflation %
LRPC
A
SRPC
Unemployment %
Assume now that this economy is allowed to return
to long-run equilibrium without government
intervention. Demonstrate the effect of this on your
graph.
Inflation %
LRPC
B
A
SRPC
SRPC2
Unemployment %
Assume that the economy is in long-run equilibrium.
Draw a correctly labeled graph of the short-run and long-run Phillips curves. Label the
long-run equilibrium point A.
Assume that consumer confidence falls. What affect will this drop in consumer
confidence have on output and price level in the short run?
Add a new point (B) to your Phillips curve that shows the short-run effect of this drop
in consumer confidence.
What effect will this have on the SRPC in the long run?
Inflation %
LRPC
A
B
SRPC2
Unemployment %
SRPC
How do changes in the inflation rate or changes in
inflationary expectations change the Long-run
Phillip’s curve?
They Don’t!
Inflation %
LRPC
SRPC
Unemployment %
Could anything shift the long-run Phillips curve?
Yes!
What?
A change in the natural rate of unemployment.
Inflation %
LRPC
Unemployment %
Assume that on-line job searches reduce the rate of
frictional unemployment. Demonstrate this using a
long-run Phillips curve.
LRPC
Inflation %
LRPC2
Unemployment %
Only a change in the
natural rate of
unemployment, or the
full employment level,
will shift the LRPC.
Changes in aggregate
demand, price level,
actual unemployment
rate, none of these
will move it!
True or False: According to the long-run Phillips
curve,
The natural rate of unemployment is independent
of monetary and fiscal policy changes that affect
aggregate demand.
Inflation %
LRPC
Unemployment %
Inflation %
Inflation and expected inflation are important
determinants of economic activity.
(a) Draw a correctly labeled graph of a short-run
Phillips curve.
SRPC
Unemployment %
Inflation and expected inflation are important
determinants of economic activity.
(b) Using your graph in part (a), show the effect of
an increase in the expected rate of inflation.
Inflation %
LRPC
SRPC2
SRPC
Unemployment %
Inflation and expected inflation are important
determinants of economic activity.
(c) What is the effect of the increase in the expected
rate of inflation on the long-run Phillips curve?
• There is no effect on the long-run Phillips curve.
The only thing that affects the long-run Phillips curve
is a change in the natural rate of unemployment!
(d) Given the increase in the expected rate of
inflation from part (b),
(i) will the nominal interest rate on new loans
increase, decrease, or remain unchanged?
It will increase.
(ii) will the real interest rate on new loans increase,
decrease, or remain unchanged?
It will not change.
(e) Assume that the nominal interest rate is 8
percent. Borrowers and lenders expect the rate of
inflation to be 3 percent, and the growth rate of real
gross domestic product is 4 percent. Calculate the
real interest rate.
• The real interest rate is 5%.