Lecture Notes 6 - Phillips Curve

Ronit Mukherji

Ashoka University

ECO 2201

1 / 18
 Foundations of the AS curve
I We used the IS-LM framework to study the Aggregate Demand Curve.
I We established what happens to the AD curve once there is a policy
change by looking at changes in Y ∗ and r∗ .
I But we have a key piece still missing- aggregate supply.
I Remember, what we did in our Classical Economics study?
=⇒ Vertical AS curve
I This was because the economy was always at full employment and prices
were completely flexible.
I In the short run, frictions in the economy will not allow it to happen.
I In the short run, as we will see, market imperfections will lead to an
upward sloping supply curve.

2 / 18
 Foundations of the AS curve

I What would be the best way to represent this AS curve or short-run

supply curve:
Y = Ȳ + α(P − EP), where α > 0
I As the equations shows, any deviations in price and expected price leads
to output being different to long-run output.
I Creates cycles in the economy or periods of expansions and recessions.
I α would tell us how much does a change in price and expected price
change output.

3 / 18
 Sticky Price Model
I Why would would supply curve be upward sloping → If prices do not
adjust immediately → firms do not change prices (wages) with a change in
demand→ Sticky prices.
I Menu Cost Hypothesis- If there are costs associated with changing
nominal prices then it may not be optimal to change P.
I When a restaurant changes the prices of the food, it has to incur the cost
of printing a new menu card.
I Lost profits from not changing price is less that costs of changing price.
I The crucial assumption here is the nature of the market. In perfect
competition, the elasticity of demand facing an individual seller is very
high so any deviation from market price leads to zero profits, therefore
prices have to completely flexible.
I However, if a firm has monopoly power the firm can get away with not
changing prices.
4 / 18
 Sticky Price Model
I There are also indirect costs to price changes
- Loss of customer goodwill
- Price cutting on a change in demand may trigger price wars.
- Collusion in an oligopolistic setting.
I Prices may not be flexible if wages are not flexible.
I Firms and workers have a wage contract which stays in effect for a long
time and are not subject to constant changes.
I ‘Efficiency wage theory’ It may be in the best interest in the firm to pay a
higher real wage. Why?
- Labour turnover is costly.
- Cost of training new workers.
- Reduces worker shirking on their job.

5 / 18
 Sticky Price Model
I A higher price level in the economy implies that the firm’s costs are
higher. Hence, the higher the overall price level, the more the firm would
like to charge for its product.
I A higher level of income raises the demand for the firm’s product.
Because marginal cost increases at higher levels of production, the
greater the demand, the higher the firm’s desired price.
I Formally, a firm’s desired price level
p = P + a(Y − Ȳ) , a > 0
I Some firms have flexible price setting given by above and others have
sticky price and they set price by taking the expected conditions in the
market:
p = EP + a(EY − EȲ)

6 / 18
 Sticky Price Model
I Assume, there s firms which set sticky prices and 1 − s who set flexible
prices. Also for simplicity, EY − EȲ = 0.
I The overall price in the economy would be a convex combination of the
two kinds of firms in the economy,
P = sEP + (1 − s)[P + a(Y − Ȳ)]
I Subtract, (1 − s)P from both sides and divide by s, we get:
P = EP + [(1 − s)a/s](Y − Ȳ)
I When output is high, demand for good is high and firms which can set a
flexible price and therefore charge a higher price.
I When expected price is high, firms with sticky prices set higher prices
which causes other firms to set higher price.
I Manipulating, our sticky price hypothesis gives, AS curve as:
Y = Ȳ + α(P − EP)
7 / 18
 Imperfect Information Model
I All prices are flexible and can adjust. However, deviations exist between
the short and long run because of temporary misperceptions about prices.
I Limited ability of people to absorb and process all information in the
economy.
I Many goods in the economy and it is not possible for a firm producing a
single good to perfectly observe all prices.
I They therefore, misperceive the relative price of their own good.
I The imperfect-information model says that when actual prices exceed
expected prices, suppliers raise their output. The model implies an
aggregate supply curve with the familiar form:
Y = Ȳ + α(P − EP)
I Output deviates from expected Y when price deviates from expected P
due to imperfect information surrounding prices.
8 / 18
 Short-run Aggregate Supply Curve

I Both the sticky price model and imperfect information model give us a
similar prediction of prices and output.
I The deviations of output from the natural level are related to deviations
of the price level from the expected price level.
I We can finally link prices to output.

9 / 18
Short-run Aggregate Supply Curve

Source: Mankiw - Macroeconomics

10 / 18
 Inflation, Unemployment, and the Phillips Curve

I The AS curve shows how an increase in output (fall in unemployment)

goes hand in hand with an increase in prices (inflation).
I The AS curve summarizes this relationship
I The Phillips Curve posits the relationship between unemployment and
inflation.
I We derive the Phillips Curve using the Aggregate Supply Curve.

11 / 18
 The Phillips Curve

I Determinates of Inflation-
. Expected Inflation
. Unemployment deviating from its natural rate, cyclical component
. Supply Shock

I Clearly, higher expectations of inflation leads to higher inflation

I From, AS curve, higher unemployment lower the inflation level.
I Exogenous supply shocks results in higher inflation
I π = Eπ − β(u − un ) + µ, Phillips Curve
I In the short run, Output is related to unexpected movements in the price
level

12 / 18
 Deriving The Phillips Curve
I We know, P = EP + (1/α)(Y − Ȳ) + µ, where µ is an exogenous supply
shock which leads to an exogenous increase in P.
I To get inflation, we subtract previous year’s price level,
P − P−1 = EP − P−1 + (1/α)(Y − Ȳ) + µ
I P − P−1 is current inflation and EP − P−1 is expected inflation.
I We have, π = Eπ + (1/α)(Y − Ȳ) + µ
I Okun’s Law, the deviation of output from its natural level is inversely
related to the deviation of unemployment from its natural rate.
(1/α)(Y − Ȳ) = −β(u − un )
I Substituting in Okuns’ Law, π = Eπ − β(u − un ) + µ
I We can derive the AS relationship from Phillips Curve.

13 / 18
 With Adaptive Expectations

I Adaptive Expectations- People expect prices to rise at the same rate as

last year, i.e., Eπ = π−1
I Phillips Curve, π = π−1 − β(u − un ) + µ
I Inflation depends on past inflation, deviation of unemployment from
natural rate, and supply shock.
I In this form, un is called non-accelerating inflation rate of unemployment,
NAIRU
I What happens if unemployment is at natural rate and there are no supply
shocks?
I Expectations play a key role in understanding and determining inflation.

14 / 18
 Causes of Inflation

I Having looked at the role of expectations we start by analysing the two

other terms in the Phillips Curve.
I Cyclical Unemployment, β(u − un ). Deviation of unemployment from
natural rate. Demand-pull inflation.
I Low unemployment =⇒ High Aggregate Demand =⇒ High inflation
I β > 0 tells us how responsive inflation is to unemployment deviating from
natural rate.
I µ Cost-push inflation. Any shock that increases prices like oil supply
reduction, implies a positive µ and hence an increase in inflation.

15 / 18
 Inflation and Unemployment Tradeoff
I When we look at what causes inflation, what factors can policy makers
control?
I Supply shocks are by nature shocks and it is often hard to control
expectations.
I However, as we have seen fiscal and monetary policy can change
aggregate demand and hence inflation.
I By reducing aggregate demand, policy makers can reduce inflation but
leads to higher unemployment.
I In the short run, for a given level of expected inflation, policymakers can
manipulate aggregate demand to choose any combination of inflation and
unemployment on this tradeoff curve, called the short-run Phillips curve.

16 / 18
Inflation and Unemployment Tradeoff

17 / 18
 Sacrifice Ratio

I In absence of expectation changes or changes in supply shocks, a

reduction in inflation is accompanied by a rise in unemployment.
I To quantify this tradeoff, policymakers must know how much output
would fall (unemployment would rise) to cause a 1% fall in inflation.
I The percentage of a year’s real GDP that must be forgone to reduce
inflation by 1 percentage point, is termed as ‘sacrifice ratio’.
I We can then combine the the sacrifice ratio with okun’s law to see the
total change in unemployment.

18 / 18