Phillips and Laffer Curves

A.W. Phillips, 1958

Inflation-Unemployment Relationship

• Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment caused by changes in AD.

• AS shocks cause• higher rates of inflation• higher rates of unemployment.

• There is no significant trade-off over long periods of time.

Annual rate of inflation

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

As inflation declines...

The Phillips Curve ConceptThe Phillips Curve Concept

Unemploymentincreases

PC

The Phillips Curve Trade-Off

UNEMPLOYMENT RATE

INF

LA

TIO

N R

AT

E

REAL OUTPUT

PR

ICE

LE

VE

L√ Increases in AD causes movements along the Phillips Curve. √ As AD changes, the tradeoff between rate of inflation and rate of unemployment moves to a new position on PC.

B

CAD1

AD2

A

AD3 Phillips curve

C

B

A

AS PC

√ If Aggregate Demand moves upward, price level rises and Real GDP rises and is reflected as a new point on the short-run Phillips curve showing higher rate of inflation and lower unemployment. √ If AD moves down, price level falls and Real GDP falls and is reflected as a new point on the short-run Phillips curve showing lower rate of inflation and Higher unemployment.

The Phillips Curve Trade-OffShort Run

Summary

Phillips Curve in the 1960s

Phillips Curve Shifting in the 70s and 80s

Phillips “Curl”

Unemployment got worse but

so did inflation.

Adverse supply shocks can cause periods of rising unemployment and

rising inflation. Rapid and significant increases in resource prices push Aggregate Supply to the

left.

Aggregate Supply and Shifting ViewsAggregate Supply and Shifting Views

o

PL1

Y1

AD1

ASsr

Price

Level

Real domestic output

PL2

Y2

PL3

Y3

AS2s

r

AS3s

r

√ The OPEC-induced price increases for oil in the 1970’s and the agricultural problems, depreciated dollar, a rise in wages following the wage-price control and declining productivity of mid 70’s announced STAGFLATION.

√ In the later 80 and 90’s, the effect of high unemployment and hence smaller increases in wages were coupled with foreign competition that held down prices and wages. Deregulation and the decline of OPEC’s power pushed the rates back closer to the earlier tradeoff picture. The ASsr shifted back to its old position and the ASlr adjusted.

Historical Evidence

Changes in AS move the Phillips Curve

o

PL1

Y1

AD1

ASsr

Price

Level

Real domestic output

PL2

Y2

PL3

Y3

AS2s

r

AS3s

r

Annual rate of inflation

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

PC1

PC2

PC3

15%SRPC3

SRPC1

SRPC2

a1

a2

a3

b1

b2

b3

PC1

PC2

PC3

LRPC

Inflat.Gap

Recess.Gap

Inflation

Rate

Unemployment Rate

12%

9%

6%

3%

02% 4% 6% 8% 10%

Phillips Curve Long RunAD changes move along the Philllips Curve

AS changes move the Phillips Curve

1. Increases in AD beyond full employment temporarily boost profits, output and

employment. (a1 to b1).

2. Nominal wages eventually catch up to sustain real wages; profit fall, canceling the short-run effect with employment returning

to its full employment level.(b1 to a2), but

at higher inflation.

3. The cycle starts again as AD grows, profits

grow and employment rises (a2 to b2)

4. Again, in time, nominal wages catch up and employment returns to its natural rate. The reward is a higher inflation rate.

Phillips Curve Long Run

√ The long-run Phillips curve is the vertical

line through a1, a2, and a3 at the natural rate

of unemployment.

√ Any rate of inflation is consistent with the 5% natural rate of unemployment.

√ After all nominal wage adjustments to increases or decreases in inflation have occurred, the economy ends up back at full-employment natural rate position.

The Phillips Curve —Long Run Summary

SUPPLY SIDE ECONOMICS

• AS is what determines inflation, growth and unemployment

• High tax rates----hurt productivity, reduce savings/investment– Also: discourage econ activity– Tax evasion

• Low tax rates (for businesses) encourage investment– Encourage work, savings– Rewards for consumers who save decreases with higher

marginal tax rates– Encourage people to enter labor force reducing

unemployment– Increasing productivity– AS expands and keeps inflation low

0

100

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rate

(p

erce

nt)

0

100

m

n

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rate

(p

erce

nt)

0

100

m m

n

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rate

(p

erce

nt)

MaximumTax

Revenue

CRITICISMS OF THE LAFFER CURVE• Economic incentives don’t have as

large an impact• Demand-side effects of a tax cut

exceeds the supply-side effects• 1980—Reganominces supported

Laffer– Tax decreased from 50-28% and

productivity increased