Inflation, Unemployment,

and the Phillips Curve

How the Phillips curve
demonstrates the inflation-
unemployment tradeoff that
policy makers face.
 Building the Phillips Curve

     (u  u )  v
e n

The Phillips curve the deviation of and supply shocks.

states that inflation unemployment from the
depends on expected natural rate (cyclical
inflation… unemployment)…
 Building the Phillips Curve

The Phillips curve is derived

from aggregate supply.
P  P e  (1/  )(Y  Y )

First we add an exogenous

supply shock term to the right P  P  (1/  )(Y  Y )  v
e

hand side.

Then we subtract last year’s P  P1  ( P e  P1 )  (1/  )(Y  Y )  v

price level P-1 from both sides.

We can write inflation as    e  (1/  )(Y  Y )  v

π=(P–P-1) and expected
inflation as πe=(Pe–P-1).
Recall Okun’s law. Which states that
deviation of output from its natural rate
is inversely related to deviation of
unemployment from its natural rate.
(1/  )(Y  Y )    (u  u n )
By substituting we obtain the
Phillips curve.
   e   (u  u n )  v
 Building the Phillips Curve

• So the Phillips curve and the short run aggregate

supply curve essentially represent the same
economic ideas.
 Adaptive Expectations and Inflation Inertia

• The Phillips curve shows the trade-off facing policy makers

in terms of unemployment and inflation.
• To make the Phillips curve more useful we need to say what
causes expected inflation.
A simple and plausible assumption might
be that people form expectations about    1
e
future inflation based on recent inflation.

In this case, we can write the

   1   (u  u n )  v
Phillips curve as...
The first term in the Phillips curve
which states that inflation
implies that inflation has inertia and that
depends on past inflation,
inflation keeps going unless something
cyclical unemployment, and a
acts to stop it. In essence we have
supply shock.
inflation because we expect it and we
expect it because we have it.
 Inertia in AD-AS

• In the AD-AS P
framework inflation
inertia is AS
characterized by
persistent upward
shifts of both AD and
AD
AS.
Q
Most often the upward shifting
aggregate demand curve is caused
by persistent growth in the money
supply.

Aggregate supply shifts up

because of expected inflation.
 Inertia in AD-AS
AS would stop
Suppose the central bank is pursuing shifting up.
an expansionary monetary policy
causing AD to shift out. P

If prices have been rising quickly, AS

people will expect them to continue to
do so. Because AS depends on
expected inflation the AS curve will
continue to shift upward.
AD
It will continue to shift upward until
some event, such as a recession or a Y
supply shock, changes inflation and
thereby changes expectations of P  P e  (1/  )(Y  Y )
inflation.
This would cause a recession.
If for example the central bank High unemployment would
tightened the money supply, AD reduce inflation and expected
would shift back. inflation, causing inflation inertia
to subside.
 Two Causes of Rising and Falling Inflation

   1   (u  u n )  v

The second term shows that
cyclical unemployment exerts
upward or downward pressure
on inflation. Low
unemployment pulls inflation
up. This is called demand-
pull inflation because high
AD is the cause.
The third term shows that
inflation also rises and
falls with supply shocks.
An adverse supply shock
would push production
prices up. This type of
inflation is called cost-
push inflation.
 The Short Run Tradeoff Between Inflation and
Unemployment
• While expected inflation and
supply shocks are beyond the
policy maker’s control, in the π
short-run the policy maker can use
monetary or fiscal policy to shift
the AD curve thus affecting output,
unemployment, and inflation. β

• A plot of the Phillips curve shows 1

the short-run tradeoff between πe+v
inflation and unemployment.
u
un

A policymaker who controls AD can choose

a combination of inflation and unemployment
on this short-run Phillips curve.
 The Short Run Tradeoff Between Inflation and
Unemployment

• Because people adjust their

expectations of inflation over π
time, the tradeoff between
inflation and unemployment
holds only in the short run.
β
• In the long run, expectations
adapt, inflation returns to 1
whatever rate the policymaker πe+v
has chosen, and unemployment
returns to the natural rate. u
un

An increase in expected inflation

causes the curve to shift upward.

So that at any unemployment rate

there will be higher inflation.
 Conclusions

• In this section we discussed the Phillips curve. The

Phillips curve demonstrates the inflation-
unemployment tradeoff that policy makers face.