UNIVERSITY OF TORONTO
DEPARTMENT OF ECONOMICS
University of Toronto Scarborough
ECMC06 – TOPICS IN MACROECONOMIC THEORY
Aggregate Demand, Aggregate Supply, and the Phillips Curve
As explained in the class the Phillips curve and the AS-AD model are connected:
- Shifts in aggregate demand push inflation and unemployment in opposite directions in
the short run. This can be illustrated on the AS-AD model, but the Phillips curve shows
the tradeoff more explicitly. In the AS-AD framework monetary and fiscal policy shift
the aggregate demand curve, which implies a move along the Phillips curve in the short
-Expansionary monetary (or fiscal) policy moves the economy along the Phillips
curve to the left (decrease in the unemployment rate & an increase in the inflation
-Contractionary monetary (or fiscal) policy moves the economy along the Phillips
curve to the right (increase in the unemployment rate, but lower inflation).
ECMC06 – Note-1 Page 1 of 1 Shifts in the Phillips Curve: Role of Expectations
Long-run Phillips Curve
The unemployment rate in the long run is independent of prices, monetary changes, etc.
Therefore, the long-run Phillips curve is vertical (independent of the variable on the
vertical axis). In fact, we also know where this vertical long-run Phillips curve will
intersect the horizontal axis: at the natural rate of unemployment.
The long-run Phillips curve conveys an important point about monetary and fiscal policy:
they can’t influence the unemployment rate in the long run because it will tend to its
natural rate. (Neoclassical/Friedman Phillips Curve)
Expectations and the Short-run Phillips Curve
There is more than one short-run Phillips curve. There is one for each rate of expected
- The Intersection of the SR Phillips curve and the LR Phillips curve is the expected
rate of inflation.
- We have an economy that is in long-run equilibrium with low inflation (say, 2%).
- The Bank of Canada uses expansionary monetary policy to lower unemployment in
the economy. Therefore, we move along the Phillips curve to the left.
- This brings us to a higher rate of inflation in the economy (4% perhaps). Once the
inflation rate is at this new level, people change their expectation. They begin to
expect it will stay at that level => prices and wages adjust accordingly.
- As a result, a long-run equilibrium is reached where the expected inflation rate is at
this new level (4%) but the unemployment rate will, of course, be at its natural rate.
This new equilibrium us stable (long run) therefore the economy will tend t