{{The Phillips The Phillips CurveCurve

In a 1958 paper, New Zealand born economist, In a 1958 paper, New Zealand born economist, A.W. Phillips published the results of his A.W. Phillips published the results of his research on the historical relationship between research on the historical relationship between the unemployment rate (u%) and the rate of the unemployment rate (u%) and the rate of inflation (π%) in Great Britain. His research inflation (π%) in Great Britain. His research indicated a stable inverse relationship between indicated a stable inverse relationship between the u% and the π%. As u%↓, π%↑ ; and as uthe u% and the π%. As u%↓, π%↑ ; and as u%↑, π%↓. The implication of this relationship %↑, π%↓. The implication of this relationship was that policy makers could exploit the trade-was that policy makers could exploit the trade-off and reduce u% at the cost of increased π%. off and reduce u% at the cost of increased π%. The Phillips curve was used as a rationale for The Phillips curve was used as a rationale for the Keynesian aggregate demand policies of the Keynesian aggregate demand policies of the mid-20the mid-20thth century. century.

The Phillips CurveThe Phillips Curve

If an economy has inflation, usually due to If an economy has inflation, usually due to demand pull growth, then more workers are demand pull growth, then more workers are being hired to produce more goodsbeing hired to produce more goods

If an economy is in a recession, more If an economy is in a recession, more resources are being left idle, thus workers resources are being left idle, thus workers aren’t needed in great demand, resulting in aren’t needed in great demand, resulting in less inflationless inflation

Movement along the Phillips Curve Movement along the Phillips Curve represents year to year changes in the represents year to year changes in the business cyclebusiness cycle

AssumptionsAssumptions

The Phillips CurveThe Phillips Curve(hypothetical example)(hypothetical example)

π%

u%

PC

4%

2%

7%5%

.. ..

.. .

Note: Inflation Expectations are held constant

In the 1970’s the United States experienced In the 1970’s the United States experienced concurrent high u% & π%, a condition known concurrent high u% & π%, a condition known as stagflation (or cost push inflation). 1976 as stagflation (or cost push inflation). 1976 American Nobel Prize economist Milton American Nobel Prize economist Milton Friedman saw stagflation as disproof of the Friedman saw stagflation as disproof of the stable Phillips Curve. Instead of a trade-off stable Phillips Curve. Instead of a trade-off between u% & π%, Friedman and 2006 Nobel between u% & π%, Friedman and 2006 Nobel Prize recipient Edmund Phelps believed that Prize recipient Edmund Phelps believed that the natural u% was independent of the π%. the natural u% was independent of the π%. This independent relationship is now referred This independent relationship is now referred to as the Long-Run Phillips Curve. to as the Long-Run Phillips Curve.

Trouble for the Phillips Trouble for the Phillips CurveCurve

Trouble for the Phillips Trouble for the Phillips CurveCurve

π%

u%

PC

4%

2%

7%5%

.. ..

.. .

..

..

.

...

Trouble for the Phillips Trouble for the Phillips CurveCurve

π%

u%

4%

2%

7%5%

.. ..

.. .

..

..

.

..

LRPC

un%

The Long-Run Phillips The Long-Run Phillips CurveCurve

π%

u%

LRPC

un%Note: Natural rate of unemployment is held

constant

Because the Long-Run Phillips Curve Because the Long-Run Phillips Curve exists at the natural rate of exists at the natural rate of unemployment (uunemployment (unn), structural changes in ), structural changes in the economy that affect uthe economy that affect un n will also cause will also cause the LRPC to shift.the LRPC to shift.

Increases in uIncreases in un n will shift LRPC will shift LRPC Decreases in uDecreases in un n will shift LRPC will shift LRPC

The Long-Run Phillips The Long-Run Phillips Curve (LRPC)Curve (LRPC)

Today many economists reject the concept of a stable Phillips Today many economists reject the concept of a stable Phillips curve, but accept that there may be a short-term trade-off curve, but accept that there may be a short-term trade-off between u% & π% given stable inflation expectations. Most between u% & π% given stable inflation expectations. Most believe that in the long-run u% & π% are independent at the believe that in the long-run u% & π% are independent at the natural rate of unemployment. Modern analysis shows that the natural rate of unemployment. Modern analysis shows that the SRPC may shift left or right. The key to understanding shifts in SRPC may shift left or right. The key to understanding shifts in the Phillips curve is inflationary expectations!the Phillips curve is inflationary expectations!

The Short-Run Phillips The Short-Run Phillips Curve (SRPC)Curve (SRPC)

The Short-Run Phillips Curve The Short-Run Phillips Curve (SRPC)(SRPC)

π%

u%

SRPC

4%

2%

7%5%

.. ..

.. .

..

.. ...

The Short-Run Phillips Curve The Short-Run Phillips Curve (SRPC)(SRPC)

π%

u%

SRPC

4%

2%

7%5%

.. ..

.. .

..

.. ...

SRPC1

SRPC (π^ %)

LRPC

π %

uN%

A

B Cπ1 %

u%

SRPC (π1^ %)

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).

Reconciling the LRPC and Reconciling the LRPC and SRPCSRPC

π%

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.

In the short-run, assuming the policy is successful, inflation occurs and unemployment decreases as the economy moves from A to B.

SRPC (π^ %)

LRPC

π %

uN%

A

BCπ1 %

u%

SRPC (π1^ %) 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).

Reconciling the LRPC and Reconciling the LRPC and SRPCSRPC

π%

u%

Now assume that either the government or the central bank enacts a contractionary policy to reduce inflation from it’s current rate at point AIn the short-run, assuming the policy is successful, disinflation occurs and unemployment increases as the economy moves from A to B.

Changes in the AS/AD model can also be seen Changes in the AS/AD model can also be seen in the Phillips Curvesin the Phillips Curves

An easy way to understand how changes in the An easy way to understand how changes in the AS/AD model affect the Phillips Curve is to AS/AD model affect the Phillips Curve is to think of the two sets of graphs as mirror think of the two sets of graphs as mirror images.images.

NOTE: The 2 models are not equivalent. The NOTE: The 2 models are not equivalent. The AS/AD model is static, but the Phillips Curve AS/AD model is static, but the Phillips Curve includes change over time. Whereas AS/AD includes change over time. Whereas AS/AD shows one time changes in the price-level as shows one time changes in the price-level as inflation or deflation, The Phillips curve inflation or deflation, The Phillips curve illustrates continuous change in the price-level illustrates continuous change in the price-level as either increased inflation or disinflation.as either increased inflation or disinflation.

Relating Phillips Curve Relating Phillips Curve to AS/ADto AS/AD

Increase in AD = Up/left Increase in AD = Up/left movement along SRPCmovement along SRPC

C↑, IG↑, G↑ and/or XN↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left

along SRPC

GDPR

PL

AD

SRASLRAS

YF

P

Y

AD1

P1

SRPC

π

u

π%

u%un

π 1

. .. .

Decrease in AD = Decrease in AD = Down/right along SRPCDown/right along SRPC

C↓, IG↓, G↓ and/or XN↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right

along SRPC

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

AD1

P1

u%

π%

SRPC

un

π

u

π1

. .. .

SRAS SRAS = SRPC = SRPC

Inflationary Expectations↓, Input Prices↓, Productivity↑, Business Taxes↓, and/or

Deregulation .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC

(Disinflation)

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

SRAS1

P1

u%

π% SRPCLRPC

un

π

u

SRPC1

π1

. .. .

SRAS SRAS = SRPC = SRPC

Inflationary Expectations↑, Input Prices↑, Productivity↓, Business Taxes↑, and/or Increased

Regulation .: SRAS .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC

(Stagflation)

GDPR

PL

AD

SRASLRAS

YF

P

Y1

SRAS1

P1

u%

π% SRPC

LRPC

un

π

u1

SRPC1

π 1. .. .

There is a short-run trade off between u% & π%. This is There is a short-run trade off between u% & π%. This is referred to as a short-run Phillips Curve (SRPC)referred to as a short-run Phillips Curve (SRPC)

In the long-run, no trade-off exists between u% & π%. This In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)is referred to as the long-run Phillips Curve (LRPC)

The LRPC exists at the natural rate of unemployment (uThe LRPC exists at the natural rate of unemployment (unn).). uun n ↑ .: LRPC ↑ .: LRPC uunn ↓ .: LRPC ↓ .: LRPC

ΔC, ΔIΔC, ΔIGG, ΔG, and/or ΔX, ΔG, and/or ΔXNN = Δ AD = Δ along SRPC = Δ AD = Δ along SRPC AD AD .: GDP .: GDPRR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC AD AD .: GDP .: GDPRR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPCΔ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC SRAS SRAS .: GDP .: GDPRR↑ & PL↓ .: u%↓ & π%↓ .: SRPC ↑ & PL↓ .: u%↓ & π%↓ .: SRPC SRAS SRAS .: GDP .: GDPRR↓ & PL ↑ .: u%↑ & π%↑.: SRPC ↓ & PL ↑ .: u%↑ & π%↑.: SRPC SummarySummary