The Phillips The Phillips CurveCurveJeff KnightJeff Knight

AP EconomicsAP Economics

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

π%

u%

PC

4%

2%

7%5%

.. .

.

.

. .

Note: Inflation Expectations are held constant

Trouble for the Phillips Trouble for the Phillips CurveCurve

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. 1976 American Nobel Prize as stagflation. 1976 American Nobel Prize economist Milton Friedman saw stagflation as economist Milton Friedman saw stagflation as disproof of the stable Phillips Curve. Instead of disproof of the stable Phillips Curve. Instead of a trade-off between u% & π%, Friedman and a trade-off between u% & π%, Friedman and 2006 Nobel Prize recipient Edmund Phelps 2006 Nobel Prize recipient Edmund Phelps believed that the natural u% was independent believed that the natural u% was independent of the π%. This independent relationship is now of the π%. This independent relationship is now referred to as the Long-Run Phillips Curve. I referred to as the Long-Run Phillips Curve. I believe it’s relevant that by this time the believe it’s relevant that by this time the Bretton-Woods system had collapsed.Bretton-Woods system had collapsed.

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

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

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

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 A

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

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

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.

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

. .. .

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

. .. .

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%SRPC

LRPC

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

SRAS

LRAS

YF

P

Y1

SRAS1

P1

u%

π%

SRPC

LRPC

un

π

u1

SRPC1

π 1. .. .

SummarySummary 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 is In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)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 Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPCBusiness 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

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

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 ), structural changes in the economy that affect changes in the economy that affect uun n will also cause the LRPC to shift.will also cause 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 Short-Run Phillips The Short-Run Phillips Curve (SRPC)Curve (SRPC)

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

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

π%

u%

SRPC

4%

2%

7%5%

.. .

.

.

. ...

.. .

..

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