Lecture Notes -- The Phillips Curve
Phillips curve: A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy. stagflation: Inflation. the short-run relationship between inflation "Phillips Curve, to " illustrates. The Phillips curve given by A.W. Phillips shows that there exist an inverse relationship between the rate of unemployment and the rate of increase in nominal.
Some of this criticism is based on the United States' experience during the s, which had periods of high unemployment and high inflation at the same time. MundellRobert E. LucasMilton Friedmanand F.
Theories based on the Phillips curve suggested that this could not happen, and the curve came under a concerted attack from a group of economists headed by Milton Friedman.
In this he followed eight years after Samuelson and Solow  who wrote "All of our discussion has been phrased in short-run terms, dealing with what might happen in the next few years.
It would be wrong, though, to think that our Figure 2 menu that related obtainable price and unemployment behavior will maintain its same shape in the longer run.
- The Phillips Curve (Explained With Diagram)
- The Phillips curve
What we do in a policy way during the next few years might cause it to shift in a definite way. Unemployment would then begin to rise back to its previous level, but now with higher inflation rates.
This result implies that over the longer-run there is no trade-off between inflation and unemployment.
This implication is significant for practical reasons because it implies that central banks should not set unemployment targets below the natural rate. Work by George AkerlofWilliam Dickensand George Perry implies that if inflation is reduced from two to zero percent, unemployment will be permanently increased by 1.
This is because workers generally have a higher tolerance for real wage cuts than nominal ones. The economy moves along the Phillips curve in the right-hand chart from point A to point B. This story leads to an important generalization. Any factor that shifts the Aggregate Demand curve, moves the economy along the short-run Phillips curve. When the Aggregate Demand curve shifts to the right, the economy moves up and to the left on the short-run Phillips curve because the price level rises corresponding with a rise in inflation, while the level of output increases, which decreases unemployment.
Conversely, when the Aggregate Demand curve shifts to the left, the economy moves down and to the right on the short-run Phillips curve. Point B in both charts cannot be a long-run equilibrium since the economy is not at potential output nor at full employment. The high level of output relative to potential output eventually increases wages as workers become more difficult to find and employ. This increase in input costs shifts to the left the Aggregate Supply curve in the left-hand chart to point C.
In the right-hand chart of the Phillips curve, the economy moves from point B to point C, reflecting the higher inflation and the higher unemployment. Point C in both charts is a long-run equilibrium. Observe points A and C in the right-hand chart. The unemployment rate is identical but the rate of inflation at point C is much higher than at point A.
This transition demonstrates the principle behind long-run Phillips curve such that in the long-run there is no tradeoff between inflation and unemployment.
Both charts begin at point A, points in which the economy is in a long-run equilibrium. The leftward shift of the Aggregate Demand curve decreases the price level and output, moving the short-run equilibrium to point B in the left-hand chart. As a consequence, the economy experiences lower inflation and higher unemployment, represented by the movement from point A point B in the right-hand chart. In the long run, the Aggregate Supply curve shifts to the left in the left-hand chart as wages decline in response to the excess unemployment.
Eventually the economy moves to point C, again a long-run equilibrium.
We illustrate this scenario by a move along the Phillips curve from point B to point C in the right-hand chart. The Role of Expectations The short-run tradeoff between inflation and unemployment is thought to work because people have an idea of what inflation expectations are going to be, and those expectations change slowly.
When the Aggregate Demand curve shifts to the right, prices and output increase. This shift increases inflation and lowers unemployment. Firms respond to this situation by attempting to hire workers. Workers view the wage offered as "good" since they do not expect that prices will rise also. But in the long-run, workers learn that inflation has risen and they are no longer happy with their wage, so they increase their inflation expectations.
Workers demand larger increases in wages which forces firms to lay off some workers until the economy arrives back at the natural rate of unemployment. We can express the Phillips curve as an equation in the following manner: The long-run Phillips curve equation suggests that the inflation rate is entirely determined by inflation expectations. As the figure titled "Inflation Expectations and the Phillips Curve" illustrates, when inflation expectations rise, the Phillips curve shifts upward.
In particular, when inflation expectations rise from 3 percent to 6 percent, the short-run Phillips curve shifts upward until the inflation rate is 6 percent when the economy is at the natural rate of unemployment. Now we can understand the differences between the short-run and long-run Phillips curves.
In the short run, an increase in Aggregate Demand does move the economy up to the left along the short-run Phillips curve. Output and inflation increase while unemployment decreases. Over the longer term, however, inflation expectations increase and workers no longer work the extra hours because they realize that real wages have not increased with the increase in prices.
It offers the policy makers to chose a combination of appropriate rate of unemployment and inflation. Wage — Unemployment Relationship: Relationship between gw and the level of employment Why are wages sticky? Or Why nominal wages adjust slowly to changes in demand? According to the Neo-Classical theory of supply, wages respond and adjust quickly to ensure that output is always at full-employment level.
This is because wages and prices are completely flexible. Therefore, the economy will always produce full employment output but the Phillips curve suggests that wages adjust slowly in response to changes in unemployment to ensure that output is at full employment level.
The Phillips Curve (Explained With Diagram)
The wages are sticky and therefore they move slowly over the time. They are not fully and immediately flexible, to ensure full employment at every point in time. To understand wage stickiness, the Phillips curve relationship is translated into a relationship between the rate of change of wages gw and the level of employment.
Wage employment relation shows that: