Pump Primer: 34
• Draw the long-run equilibrium in
the AD/AS framework.
• Show what happens in the short
run when AD increases
• Explain what happens in the long
run.
Module 34
Inflation and
Unemployment:
The Phillips Curve
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration:
• We should always demonstrate a Christ-like
love for all our neighbors and to love them as
ourselves. The cycles of our economy can
cause hardships in our families and
communities. So, the question for us to
examine is how can we make a difference?
(See Duet.15:7-8)
What you will learn
in this Module:
• What the Phillips curve is and the nature of the
short-run trade-off between inflation and
unemployment
• Why there is no long-run trade-off between
inflation and unemployment
• Why expansionary policies are limited due to
the effects of expected inflation
• Why even moderate levels of inflation can be
hard to end
• Why deflation is a problem for economic policy
and leads policy makers to prefer a low but
positive inflation rate
The Short-Run Phillips Curve
We have seen that there is a short-run trade-off
between unemployment and inflation—lower
unemployment tends to lead to higher
inflation, and vice versa. The key concept is
that of the Phillips Curve.
The Short-Run Phillips Curve
When AD increases along the SRAS, the
unemployment rate falls and the inflation rate rises
(a movement from point a to point b below).
When AD decreases along the SRAS, the
unemployment rate rises and the inflation rate falls
(a movement from point b to point a below).
Note: A shift in AD will cause a movement along the
SRPC.
The Short-Run Phillips Curve
This allows us to draw a
downward sloping
relationship between the
unemployment rate and the
inflation rate. This is known
as the short-run Phillips
curve.
When SRAS increases
along the AD, both the
unemployment and inflation
rates fall. This is seen as a
downward shift of the
SRPC.
The Short-Run Phillips Curve
When SRAS decreases
along the AD, both the
unemployment and inflation
rates rise.
This is seen as an upward
shift of the SRPC.
(Note: The SRPC can extend
below the horizontal axis, but
cannot extend to the left of
the vertical axis.)
Inflation Expectations and the
Short-Run Phillips Curve
The expected rate of inflation is the rate of
inflation that employers and workers expect in
the near future.
One of the crucial discoveries of modern
macroeconomics is that changes in the expected
rate of inflation affect the short-run trade-off
between unemployment and inflation and shifts
the short-run Phillips curve.
Inflation Expectations and the
Short-Run Phillips Curve
Workers care about future inflation. If
inflation is expected to be high in coming
months, wage contracts should reflect that
expectation and nominal wages will be
increased.
In fact, both workers and employers will
factor expected inflation into all wage and
price contracts because nobody wants to
lose purchasing power due to future
inflation.
Inflation Expectations and the
Short-Run Phillips Curve
For these reasons, an increase in
expected inflation shifts the shortrun Phillips curve upward: the
actual rate of inflation at any given
unemployment rate is higher when
the expected inflation rate is higher.
In fact, macroeconomists believe
that the relationship between
changes in expected inflation and
changes in actual inflation is one-toone. That is, when the expected
inflation rate increases, the actual
inflation rate at any given
unemployment rate will increase by
the same amount. Why?
Inflation Expectations and the
Short-Run Phillips Curve
Suppose inflation has been near zero for years,
but gradually people begin to expect inflation of
3%.
Nominal wages and other contracts begin to
reflect a future increase of 3%. As these wages
and other resource prices rise by 3%, actual
inflation begins to rise from about zero to 3%.
So inflation expectations translate into actual
inflation rates.
Inflation Expectations and the
Short-Run Phillips Curve
Higher inflation expectations shift the SRPC
upward. At any level of unemployment, inflation
will be that much higher.
Of course this works in reverse. Lower inflation
expectations shift the SRPC downward.
Inflation and Unemployment
in the Long Run
• Most macroeconomists believe that
there is, in fact, no long-run trade-off
between lower unemployment rates
and higher inflation rates. That is, it is
not possible to achieve lower
unemployment in the long run by
accepting higher inflation.
Inflation and Unemployment
in the Long Run
• Assume the economy is currently in
long-run equilibrium and real GDP is at
the level of full employment.
• The unemployment rate at fullemployment is 5% and because the
economy is in LR equilibrium, inflation is
zero.
• This is seen as point A on SRPC0.
The Long-Run Phillips Curve
Inflation and Unemployment
in the Long Run
• Suppose now the government
increases AD through either
expansionary fiscal or monetary
policy.
• AD shifts right, the unemployment
rate falls to 3% but inflation rises to
2%. This is point B on SRPC0.
The Long-Run Phillips Curve
Inflation and Unemployment
in the Long Run
• Eventually inflation expectations
adjust to 2% and nominal wages rise
by 2%. The SRAS shifts upward to
long-run equilibrium and so does
the SRPC.
• What if the government attempts to
keep unemployment at 3%? Before
too long, this will cause more
inflation to 4%, shifting the SRPC up
to SRPC1.
The Long-Run Phillips Curve
Inflation and Unemployment
in the Long Run
• Instead, if the government allows the
economy to adjust to an inflation rate of
2%, eventually the economy returns to
full employment at unemployment of 5%
and new inflation of 2%. This is point C
on SRPC1.
• As AD shifts to the right or left in the
short run, eventually the economy
returns to an unemployment rate of 5%
and possibly a higher, or lower, rate of
inflation.
The Long-Run Phillips Curve
If we connect long-run points like points
A and C, we can draw a long-run
Phillips curve (LRPC).
An unemployment rate of 3% will cause
inflation to accelerate.
The unemployment rate at which
inflation does not change over time—
5% in the graph above, is known as the
non-accelerating inflation rate of
unemployment, or NAIRU for short.
The Long-Run Phillips Curve
Keeping the unemployment
rate below the NAIRU leads to
ever-accelerating inflation and
cannot be maintained. Most
macroeconomists believe that
there is a NAIRU and that there
is no long-run trade-off
between unemployment and
inflation.
The Natural Rate of Unemployment, Revisited
Recall the concept of the natural rate of
unemployment, the portion of the unemployment rate
unaffected by the swings of the business cycle.
Now we have introduced the concept of the NAIRU.
How do these two concepts relate to each other?
The answer is that the NAIRU is another name for the
natural rate. The level of unemployment the economy
“needs” in order to avoid accelerating inflation is equal
to the natural rate of unemployment.
The Costs of Disinflation
An effort to reduce unemployment below NAIRU will cause
inflation. What about an effort to reduce inflation?
The government must create a situation, with
contractionary fiscal/monetary policy, where the
unemployment rate is above NAIRU. This induced
recession, should decrease the inflation rate to the point
where the SRPC shifts downward.
Once inflation is under control, the economy can adjust
back to the NAIRU.
This process of disinflation is painful because of a period
of high unemployment.
The Costs of Disinflation
Deflation
• Why is deflation a problem? And, why is it
hard to end?
A. Debt Deflation
• Due to the falling price level, a dollar in the
future has a higher real value than a dollar
today. So lenders, who are owed money,
gain under deflation because the real value
of borrowers’ payments increases.
• Borrowers lose because the real burden of
their debt rises.
• What do you expect borrowers to do? Cut
back on spending.
• So, weak spending causes deflation, which
causes less spending, which causes
deflation….
Deflation
B. Effects of Expected Deflation
• We have already seen that interest rates are
affected by inflation expectations.
• What about deflation?
• Nominal rate = real rate + expected
inflation
• Suppose the rr=2% and expected inflation =
3%, then the nominal rate = 5%.
• But what if there is prolonged deflation and
expected inflation is -2%, the nominal rate is
0%.
Deflation
• Interest rates cannot fall below 0%,
there is a zero bound. So deflation
creates a situation where lenders
receive nominal interest rates that
approach zero. Lending will stop.
• If the economy is extremely
depressed, which caused the
deflation in the first place, monetary
policy becomes completely
ineffective. The Fed can’t lower the
interest rate lower than 0%!! This kind
of deflation can cause an economy to
languish for a very long time.
• This is referred to as the liquidity
trap.