Expectations and the Phillips Curve
Shifting the aggregate demand (AD) curve outward causes prices and
output to increase and unemployment to decrease.
Moving along the short-run aggregate supply (SRAS) curve illustrates
the inverse relationship between unemployment and the price level shown
by the Phillips curve.
In the long run, the Phillips curve shifts upward to reflect the new
unemployment rate at the underlying rate of inflation.
The Phillips curve depends on adaptive expectations to generate the shortrun tradeoff.
Recall the long-run adjustment process
of aggregate supply and demand.
When the AD curve shifts outward,
the long-run equilibrium occurs at a
higher price level at the economy’s full
employment.
Note the short-run equilibrium at P1
and Y1. At this point the price level
and output are higher, and
unemployment is lower. Think of the
Phillips curve tradeoff: As inflation
increases, unemployment decreases.
Here we can see the Phillips curve’s
connection to the aggregate
demand/aggregate supply model.
An outward shift in the AD curve
causes higher output, higher price
levels, and lower unemployment. An
inward shift in the AD curve causes
lower output, lower price levels, and
higher unemployment.
Recall the graph of the Phillips curve.
The inverse relationship between the
unemployment rate and the inflation
rate is illustrated by the curve’s
downward slope.
Because the Phillips curve is a shortrun phenomenon, backward-looking
adaptive expectations will cause the
Phillips curve to persist.