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6-3
Phillips Curve
The PC shows the rate of growth of wage inflation decreases with
increases in unemployment
If Wt = wage this period
Wt 1 Wt
Wt+1 = wage next period
gw
gw = rate of wage inflation, then
Wt
PC is defined as: g w (u u )
*
6-4
Phillips Curve
Suppose the economy is in equilibrium with
prices stable and unemployment at the
natural rate
Wt 1 Wt
(u u * )
Wt
PC shows:
Wt 1 Wt Wt ( (u u * ))
6-5
Wt 1 Wt ( (u u * )) Wt
Wt 1 Wt [1 (u u * )]
For wages to rise above previous levels, u
must fall below the natural rate
102
Inflation
Rate
(percent
per year)
Short-run
aggregate
supply
106
A
High
aggregate demand
Low aggregate
demand
7,500 8,000
(unemployment (unemployment
is 7%)
is 4%)
Quantity
of Output
A
2
Phillips curve
0
4
(output is
8,000)
Unemployment
7
(output is Rate (percent)
7,500)
( gw e ) ( * )
6-8
e t 1 (u u* )
6-9
The equation for the modern version of the PC, the expectations augmented
PC, is:
g w e (u u * )
e (u u * ),
e (u u * )
NOTE:
Rational Expectations
Augmented Phillips Curve predicts that will rise above e when u < u*
So why dont individuals quickly adjust their expectations to match the
models prediction?
The PC relationship relies on people being WRONG about in a very predictable way
If people learn to predict , e should always equal so that u = u*
We predict u = u* in the LR, but not in the SR
Robert Lucas: a good economics model should not rely on the public
making easily avoidable mistakes
People will form expectations about inflation based on all publicly available
information
Surprise shifts in AD will change u, but predictable shifts will not
6-11
Figure illustrates the inflation expectationsaugmented Phillips curve for the 1980s and early
2000
Changes in expectations (e) shift the curve up and
down
The role of e adds another automatic adjustment
mechanism to the AS side of the economy
When high AD moves the economy up and to the
left along the SRPC, inflation results
If inflation persists, people adjust their
expectations upwards, and move to higher SRPC
6-12
1. When the
RBI increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
High
inflation
Low
inflation
Long-run
Phillips curve
B
Natural rate of
unemployment
2. . . . but unemployment
remains at its natural rate
in the long run.
Unemployment
Rate
P2
2. . . . raises
the price
P
level . . .
Long-run aggregate
supply
1. An increase in
the money supply
increases aggregate
B
demand . . .
Inflation
Rate
Long-run Phillips
curve
3. . . . and
increases the
inflation rate . . .
B
AD2
Aggregate
demand, AD
Natural rate
of output
Quantity
of Output
Natural rate of
unemployment
Unemployment
Rate
Natural rate of
unemployment
Unemployment
Rate
Copyright 2004 South-Western
AS2
P2
3. . . . and
raises
the price
level . . .
Aggregate
supply, AS
1. An adverse
shift in aggregate
supply . . .
4. . . . giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
A
PC2
Aggregate
demand
0
Y2
Y
2. . . . lowers output . . .
Phillips curve,
Quantity
of Output
PC
Unemployment
Rate
Summary.
The Phillips curve describes a negative relationship between inflation
and unemployment.
By expanding aggregate demand, policymakers can choose a point on
the Phillips curve with higher inflation and lower unemployment.
By contracting aggregate demand, policymakers can choose a point
on the Phillips curve with lower inflation and higher unemployment.
Summary
The tradeoff between inflation and unemployment described by the
Phillips curve holds only in the short run.
The long-run Phillips curve is vertical at the natural rate of
unemployment.
The short-run Phillips curve shifts because of shocks to aggregate
supply.
An adverse supply shock gives policymakers a less favorable tradeoff
between inflation and unemployment.