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ECN 204 Lecture Notes - Edmund Phelps, Phillips Curve, Aggregate Supply

Course Code
ECN 204
Paul Missios

of 5
Chapter 16: The Short Run Tradeoff between Inflation and Unemployment
Phillips Curve: a curve that shows the short-run tradeoff between inflation and unemployment
Origins of the Phillips Curve
Negative Correlation: Phillips showed that years with low unemployment tend to have high inflation
and years with high unemployment tend to have low inflation.
Aggregate Demand, Aggregate Supply, and the Phillips Curve
-The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as
shifts in the aggregate demand curve move the economy along the short run aggregate supply curve
Example: Suppose P=100 this year. There
are two possible outcomes:
A: Aggregate demand is low, small
increase in P (low inflation) and low
output, high unemployment
B: Aggregate demand is high, big
increase in P (high inflation) and high
output, low unemployment
-If aggregate demand next year is low (slow money growth) then outcome A will occur. P = 103 next year,
so the inflation rate from this year to next equals 3%. Output Y1 is relatively low, so unemployment is
relatively high at 6%.
-If aggregate demand next year is high (rapid money growth) then outcome B will occur. P=105 next
year, so the inflation rate from this year to next equals 5%. Output Y2 is higher so unemployment is
lower at 4%.
The Phillips Curve: A Policy Menu?
-Since fiscal and monetary policy affect aggregate demand, the Phillips curve appeared to offer
policymakers a menu of choices:
Low unemployment with high inflation
Low inflation with high unemployment
Anything in between
Shifts in the Phillips Curve: The Role of Expectation
The Long-Run Phillips Curve
1968: Milton Friedman and Edmund Phelps argued that the tradeoff was temporary.
Natural-rate Hypothesis: the claim that unemployment eventually returns to its normal or “natural rate”
regardless of the inflation rate Based on the classical dichotomy and the vertical Long run aggregate
supply curve.
-The greater the expansion of money supply, the faster AD
will shift to the right resulting in increases in prices
therefore higher inflation. But this higher inflation will not
produce lower unemployment: in the long run,
unemployment always goes to its natural rate whether
inflation is high or low. In the long run, faster money
growth only causes faster inflation.
The Meaning of “Natural”
-Monetary policy cannot influence the natural rate of unemployment but other policies can. Labor-
market policies such as minimum wage laws, employment insurance, and job training programs affect
the natural rate of unemployment. A policy change that reduced the natural rate of unemployment
would shift the long run Phillips curve to the left. The long run aggregate supply curve will shift to the
right because lower unemployment means more goods and services, and quantity of g&s supplied
would be larger at any given price level. The economy could then enjoy lower unemployment and higher
output for any given rate of money growth and inflation
Reconciling Theory and Evidence
Phillips theory is that PC slopes downward. Friedman and Phelps theory states that PC is vertical in the
long run.
-To bridge the gap between theory and evident, Friedman and Phelps introduced a new variable:
Expected Inflation: a measure of how much people expect the price level to change
Short Run Phillips Curve
Short Run: BOC can reduce unemployment rate below the natural u-rate by making inflation greater
than expected
Long Run: Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or
-The coefficient a is a positive number that measures the relationship between unexpected inflation and
deviations of unemployment from its natural rate. A 1% increase in inflation causes the unemployment
rate to fall by a (for given values of the natural rate and expected inflation)
-If the BOC wants to reduce unemployment below the natural rate, it has to surprise people with higher
than anticipated inflation. This result will be lower unemployment- but only until people adjust their
expectations to the new reality of higher inflation. Eventually, expectations catch up with reality, so they
adjust their expectations upwards.
How Expected Inflation shifts the Phillips Curve
-When people adjust their inflation
expectations upward, then the Phillips curve
shifts up: each value of the unemployment
rate is associated with higher inflation.
Exercise 1: Expected Inflation
Natural rate of unemployment=5%, Expected inflation=2%, In PC equation, a=0.5
A: Plot the long run Phillips curve
B: Find the u-rate for each of these values of actual
inflation: 0%, 6%. Sketch the short run PC.
C: Suppose expected inflation rises to 4%. Repeat part
D: Instead, suppose the natural rate falls to 4%. Draw
the new long run Phillips curve, then repeat part B
Shifts in the Phillips Curve: The Role of Supply Shocks
Supply Shock: an event that directly alters firm’s cost and prices, shifting the AS and PC curves. Example,
large increase in oil prices
Stagflation: the combination of rising prices and falling output