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# BAB 35

1. Show how Philip curve is derived from aggregate demand/aggregate supply model step
by step, show a diagram

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.

- The Philips curve is a relationship between the unemployment rate and the inflation rate
- To understand this relationship we need to the aggregate demand and aggregate supply
model
- We begin with the short run aggregate supply curve and a low level of aggregate demand
- In this case aggregate demand and supply combine to determine the quantity of output
and the price level.
- When output is relatively low, as at the point A. Few workers are employed and so the
unemployment rate is high. Suppose the unemployment rate at point A is 7%
- And because the economy is operating below the capacity, prices are not rising very fast,
so the inflation rate is low, perhaps 2% per year
- Therefore If the economy is at point a, we know that the unemployment rate is 7% and
the inflation rate is 2%. This gives us one point on the Philips curve
- Next what if the aggregate demand increases, As a result of the increase in aggregate
demand, output will increase, at the same time the price level will rise.
- Because output has increased more people are employed. The unemployment fallen from
7% to 4% . And the increase in the price level from 100 to 106 means that the inflation
rate has increase 6 %
- We now have another point the Philips curve, a point at which the unemployment rate is
4% and the inflation rate is 6%
- If we connect point such as point a and b in the top panel, we will get the curve called
the Philips curve
- The Philips curve are slope downward because if aggregate demand increases more
output is produced, more people are employed and there fore the unemployment rate falls
- However the increase in demand also drives up the price level, so the inflation rate is
increase
- As a result the Philips curve show a tradeoff. In the short run an economy can achieve a
lower unemployment rate but it comes at the cost of higher inflation rate

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.
The Long-Run Phillips Curve
How Expected Inflation Shifts the Short-Run Phillips Curve
natural-rate hypothesis the claim that unemployment eventually returns to its normal, or natural,
rate, regardless of the rate of inflation
supply shock an event that directly alters firms costs and prices, shifting the economys
aggregate supply curve and thus thePhillips curve
sacrifice ratio
the number of percentage points of annual output lost in the process of reducing inflation by 1
percentage point
rational expectations the theory that people optimally use all the information they have,
including information about government policies, when forecasting the future
The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply
shock, such as an increase in world oil prices, gives policymakers a less favorable trade-off
between inflation and unemployment. That is, after an adversesupply shock, policymakers have
to accept a higher rate of inflation for any given rate of unemployment or a higher rate of
unemployment for any given rate of inflation.
When the Fed contracts growth in the money supply to reduce inflation, it moves the economy
along the shortrun Phillips curve, which results in temporarily high unemployment. The cost of
disinflation depends on how quickly expectations of inflation fall. Some economists
argue that a credible commitment to low inflation can reduce the cost of disinflation by inducing