MGEC06: Philip's Curve

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Economics for Management Studies

UNIVERSITY OF TORONTO DEPARTMENT OF ECONOMICS University of Toronto Scarborough ECMC06 – TOPICS IN MACROECONOMIC THEORY Note-1 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 run. Example: -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 rate). -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 inflation. - 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
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