AP MacroPhillips Curve, Monetary

Policy

The Phillips Curve(hypothetical example)

tt%

u%

PC

4%

2%

7%5%

.. .

.

.

. .

Note: Inflation Expectations are held constant

The Phillips Curve• In a 1958 paper, New Zealand born

economist, A.W. Phillips published the results of his research on the historical relationship between the unemployment rate (u%) and the rate of inflation (tt%) in Great Britain.

• His research indicated a stable inverse relationship between the u% and the tt%. As u%↓, tt%↑ ; and as u%↑, tt%↓.

• The implication of this relationship was that policy makers could exploit the trade-off and reduce u% at the cost of increased tt%.

Trouble for the Phillips Curve

• In the 1970’s the U.S. experienced concurrent high u% & tt%, = stagflation.

• 1976 American Nobel Prize economist

Milton Friedman saw stagflation as disproof of the stable PC.

• Instead of a trade-off between u% & tt%, Friedman and 2006 Nobel Prize recipient Edmund Phelps believed that Un was independent of the tt%. This independent relationship is now referred to as the Long-Run Phillips Curve.

1970’s Phillips Curve

π%

u%

PC

4%

2%

7%5%

.. .

.

.

. ...

..

.

.

..

The Long-Run Phillips Curve

π%

u%

LRPC

un

%Note: Natural rate of unemployment is held constant

Un definedThe natural rate of unemployment (NRU) is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level

It is where the aggregate supply of labor is in balance with the aggregate demand for labor.

At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and there is no involuntary unemployment

There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions.

The Long-Run Phillips Curve (LRPC)

• b/c the LRPC exists at the un, structural changes in the economy that affect un

will also cause the LRPC to shift.

• In order to reduce the Un, structural policies must be directed towards an economy's supply side.

• Increases in un will shift LRPC

• Decreases in un will shift LRPC

Phillips Curve – LR and SR

Inflation rate

LRPC

Unemployment rate

SRPC (assumes 4 % expected inflation at each UR)

Natural rate of

unemployment

2%

4%

SRPC (assumes 2% expected inflation at each UR)

Summary• There is a short-run trade off between u% & π%.

This is referred to as a short-run Phillips Curve (SRPC)

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

• The LRPC exists at the natural rate of unemployment (un).– un ↑ .: LRPC – un ↓ .: LRPC

• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC– AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC– AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

• Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC – SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC – SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC

SRPC (tt^ %)

LRPC

tt %

uN%

A

B Ctt1 %

u%

SRPC (tt1^ %)

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 SRPC

tt%

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 SRPC

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 to AS/AD

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

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

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

Movements along the SRPC

Shifts of the SRPC• Expected TT:

If TT goes up – shift up. If TT goes down – shift down

• SRAS increases = shift SRPC right• SRAS decreases = shift SRPC left

Shifts of the LRPC

Increase in AD = Up/left movement 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 = Down/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 = 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 = 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. .. .

Phillips Curve Review

• SRAS increases = shift SRPC right• SRAS decreases = shift SRPC left

• AD increases = movement up and left • AD decreases = movement down and

right

• Increases in un will shift LRPC

• Decreases in un will shift LRPC

Money Market

NIR

Q1 Q

MD

MS

i1

• MS – affected by actions of the Federal Reserve

• MD – • Transaction demand

determined by GDP• Asset demand

determined by NIR