Deriving the Phillips Curve from AD/AS Derive the Short and Long Run Phillips Curves What

shifts the SRPC and the LRPC

Short AND Long Term Effects of INFLATION on the Phillips Curve

 Phillips

revealed in his study that there exists an inverse relationship between the rate of change in the money wage rate and the rate of unemployment. Phillips curve implies that there exists a trade off between the rate of unemployment and the rate of change in money wage rate, i.e a lower rate of unemployment can be achieved only by allowing money wage rate to increase.

 The

inverse relationship between the wage rate and the unemployment rate can be explained by: DEMAND PULL FACTOR WAGE-PUSH FACTOR

Phillips Curve
Inflation

LRAS

SRAS

.. .
B
A

Price Level PL1 PL* PL2 SRPC

RDP2

AD1 AD Real GDP

RGDP* RGDP1

AD

Unemployment

FE

The Short-Run Phillips Curve illustrates the Trade-off between Inflation and Unemployment (derived from what is happening to RGDP) that occurs as the AD curve traverses (either up or down) the UPWARD sloping (Intermediate) range of SRAS.

Phillips Curve
Inflation

LRAS

SRAS

.. .
B
A

Price Level PL1 PL* PL2 SRPC

RDP2

AD1 AD Real GDP

RGDP* RGDP1

AD

Unemployment

FE

IMPORTANT---Movement ALONG the SRPC corresponds with AD movement ALONG the Upward Sloping (Intermediate Range) of the SRAS Curve. The Phillips Curve is important because for A long timepost WWIIFiscal Policy (FP) and Monetary Policy (MP)was driven by this relationship between inflation and unemployment

Phillips Curve

Phillips Curve
Inflation

LRAS

SRAS

.. .
B
A

Price Level PL1 PL* PL2 SRPC

RDP2

AD1 AD Real GDP

RGDP* RGDP1

AD

Unemployment

FE

If Unemployment was the problem then policy makers (FP and MP) INCREASED AD to DECREASE unemployment, but this tended to create INFLATION.

Phillips Curve
Inflation

LRAS

SRAS

.. .
B
A

Price Level PL1 PL* PL2 SRPC

RDP2

AD1 AD Real GDP

RGDP* RGDP1

AD

Unemployment

FE

OrIf Inflation was the problem then policy makers (FP and MP) DECREASED AD to DECREASE Inflation, but this tended to create Unemployment.tackling the evil of the Day tended to make the other evil worse

Phillips Curve
Inflation

LRAS

SRAS

.. .
B
A

Price Level PL1 PL* PL2 SRPC

.
AD
RDP2

AD1 AD

Real GDP

Lets look at Point A on the SRPC---Notice it corresponds with the PL* and FE GDP* Which also represents the economy at is normal Long Run Equilibrium StateRemember-LRAS represents POTENTIAL, LONG TERM RGDP. At FE RGDP the unemployment rate is the Natural Rate of Unemployment. In the LONG RUN no matter how much AD increases will ALWAYS Come up against the wall of LRAS NO MATTER WHAT THE PRICE LEVEL IS!!

RGDP*

Unemployment

RGDP1

FE

Phillips Curve
Inflation

LRAS

SRAS

.. .
B
A

Price Level PL1 PL* PL2 SRPC

.
AD
RDP2

AD1 AD

Real GDP

Soif in the LONG RUN the Unemployment Rate stays at the Natural Rate of Unemployment REGARDLESS of the PRICE LEVEL, what do you think the LONG RUN PHILLIPS CURVE is going To look like??

RGDP*

Unemployment

RGDP1

FE

Phillips Curve
10% Inflation

.. .
B
A

LRPC

C SRPC

0%

NRU (5%) Unemployment

10%

The LONG RUN PHILLIPS CURVE (LRPC) is VERTICAL at the Natural Rate of Unemployment!! NO MATTER WHAT THE INFLATION RATE IS THE NRU STAYS THE SAME..

The Phillips Curve

Wage growth % (Inflation)
An inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation.

3.0%

1.5%

4%

6% PC2

PC1

Unemployment (%)

Causes of shift in Phillips Curve

According to Keynesians, the occurrence of higher inflation rate along with the increase in unemployment rate witnessed during the seventies and early eighties was due to adverse supply shocks in the form of four fold increase in the prices of oil and petroleum products delivered to the American economy first in 1973-74 and then in 1979-80.

The Long Run Phillips Curve

Inflation Long Run PC
At point A with unemployment rate of U1 and when thein unemployment ratereal wages go possible inflation rate level these rates are consistent with decrease priceof 1%,rises, the could be only down. the level decline. decreasing unemployment ifWith wagesprices andNow suppose that the policy, the real rising of output.But workers try to negotiate for a trade off rate A the renewal of their of along The rise makers consider U1 towards rate B high wagepoint at movesas a highpointcontract. the short run phillips curve SPC1 . This shows a decline in of unemployment and plans in the demand means in real wage causes a decline to reduce it by for labour. unemployment rate frommarketU. expansionary policies. Consequently, the labour U1 to begins to move towards a higher equilibrium point as shown by the path of movement from point B to C which indicates a n increase in inflation and unemployment. This is virtually a situation of Stagflation., where prices increase without increase in employment and output.

2.0%

C B F

1.0%

A U
U1 SPC1 SPC2

SPC3 Unemployment

LONG RUN PHILLIPS CURVE

What shifts the LONG RUN PHILLIPS CURVE?
Changes in government benefits to the unemployed/underemployed Changes in the composition of the Labor force Changes in Supply-Side policies

Phillips Curve
10% Inflation LRPC LRPC1

SRPC NRU NRU1 10% (5%) (7%) Unemployment Changes in Govt Benefits towards the UNEMPLOYED and the UNDEREMPLOYED If the Govt. INCREASES the benefits they pay to the unemployed/underemployed in general this produces a higher level of FRICTIONAL unemployment. People tend to stay Unemployed for longer periods of time because the replacement income they receive from the govt. is closer to their lost incomeIn other words, the incentive to look for a Job is diminished and the tendency to stay unemployed increases.. The LONG RUN PHILLIPS CURVE SHIFTS TO THE RIGHT 0%

Phillips Curve
10% Inflation LRPC1 LRPC

SRPC 0% NRU1 NRU 10% (3%) (5%) Unemployment Changes in Govt Benefits towards the UNEMPLOYED and the UNDEREMPLOYED If the Govt. DECREASES the benefits they pay to the unemployed/underemployed in general this produces a lower level of FRICTIONAL unemployment. People tend to stay Unemployed for shorter periods of time because the replacement income they receive from the govt. is much LESS then their original incomeIn other words, the incentive to look for a job is INCREASES and the tendency to stay unemployed DECREASES... The LONG RUN PHILLIPS CURVE SHIFTS TO THE LEFT

 We

will use as an example

LRPC INFLATION

Price Level

LRAS
SRAS

PL*

6%
RGDP*

AD*

RGDP

SRPC

NRU
UNEMPLOYMENT The INFLATION RATE currently is 6% and the RBI believes that is too HIGH. They decide to target 3% as a preferred level of Inflation.

LRPC INFLATION

Price Level

SRAS

PL*

6%
RGDP*

AD*

RGDP

SRPC

NRU
UNEMPLOYMENT In order to DECREASE INFLATION the RBI would carry out the Open Market Operation or SELLING BONDS---this will DECREASE the Money Supply and INCREASE the BANK RATE and tend to INCREASE INTEREST RATES throughout the Financial System.

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP

SRPC

NRU
UNEMPLOYMENT INCREASING INTEREST RATES will cause AD to DECREASE

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP

SRPC

NRU
UNEMPLOYMENT REAL GDP will DECREASE AND PRICE LEVEL (inflation) will DECREASE AND Because RGDP DECREASES, UNEMPLOYMENT will INCREASE

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT INFLATION is DECREASING and UMEPLOYMENT IS INCREASING---There is MOVEMENT ALONG THE PHILLIPS CURVE IN THE SHORT RUN

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT The Economy settles at a LOWER INFLATION RATE and a HIGHER UNEMPLOYMENT RATE

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT NOTE: This is the situation in the SHORT-RUN---What is the LONG-TERM EFFECT of the RBI action?

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT People (and business and govt) EXPECTIONS about INFLATION are now going to Be built-in---They have expectations of LOWER PRICES AND WAGES.

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT This will affect a number of things BUT lets focus on WAGES

LRPC INFLATION

Price Level

SRAS

PL* PL1

6%
RGDP1 RGDP*

AD* AD1

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT Because there are expectations of LOWER Inflation then WAGES tend to Stabilize and MAY decrease (assume this to be the case)On the AD/AS Graph, which curve is going to be affected???

LRPC INFLATION

Price Level

SRAS

SRAS1

PL* PL1 PL2

6%
RGDP1 RGDP*

AD* AD1
RGDP2

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT Aggregate Supply!! Cost of Production will tend to DECREASEWhen C.O.P DECREASES then Aggregate Supply will INCREASE (Shift to the Right)

LRPC INFLATION

Price Level

SRAS

SRAS1

PL* PL1 PL2

6%
RGDP1 RGDP*

AD* AD1
RGDP2

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT Price Level (inflation) has DECREASED and RGDP has INCREASED (back to the original FE FGDP* therefore UNEMPLOYMENT has DECREASED.

LRPC INFLATION

Price Level

SRAS

SRAS1

PL* PL1 PL2

6%
RGDP1 RGDP*

AD* AD1
RGDP2

RGDP
3% SRPC

NRU

UR1

UNEMPLOYMENT How does this affect the Phillips Curve??? When the SRAS curve shifts to the RIGHT The Short-Run Phillips Curve shifts to the LEFT!! Now at every level of UNEMPLOYMENT the PRICE LEVEL will be LOWER.

LRPC INFLATION

Price Level

SRAS

SRAS1

PL* PL1 PL2

6%
RGDP1 RGDP*

AD* AD1
RGDP2

RGDP
3%
Economy is BACK to FE where AD = SRAS=LRAS We are STILL at the NRU but at a LOWER I INFLATION RATE!!

SRPC

NRU

UR1

UNEMPLOYMENT With the shift of The Short Run Phillips Curve we move back to Long-Run Equilibrium where SRPC intersect LRPC at the NRU.THE LONG RUN PHILLIPS CURVE IS NOT GOING TO SHIFT.

Policy implication of the Long-Run Phillips Curve

There is a minimum level of unemployment which an economy will have to tolerate in the long run. This unemployment cannot be reduced in the long run through policy measures. The efforts to contain unemployment below its natural rate and inflation rate below one associated with the natural rate of unemployment have a great chance proving unproductive.

Rational Expectation Theory

Nominal wage lag behind changes in the price level. This lag leads to business profits which induces the firms to expand output and employment in the short run and leads to reduction in unemployment rate below the natural rate. Rational expectation theory rests on two basic elements: Workers and producers are rational and they have correct understanding of the economy. All the product and factor markets are highly competitive.

Rational Expectation Theory

S

p1
p

Eq

D1
D

36

The End