PGP Macroeconomics

Session 14

1
The Phillips Curve

The Phillips curve provides a trade-off between inflation and

unemployment.

• Used through the 1960’s for policy choice

• Theoretical basis was questioned in 1968 by Milton Friedman and

Edmund Phelps

• Evidence in the 1970s’ supported them

• Revolutionized macroeconomics

• Distinguish between short run and long run

• Importance of Expectations in Macroeconomics 2
 The Phillips Curve

Inflation
Rate
(percent
per year)

6 B

A
2

Phillips curve

0 4 7 Unemployment
Rate (percent)
3
 The Phillips Curve in the 1960s
Inflation Rate
(percent per year)

10

1968
4
1966
1967

2 1962
1965
1964 1961
1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent) 4
UK: The Original Phillips Curve

5
Economic Theory and the Phillips Curve

• The Phillips Curve is an empirical relationship

• Does it make economic sense?

• What is the theory behind it?

• Appears to be useful for policy making –

-- But is it a stable relation?

6
Theory: AD-AS and the Phillips Curve

• The Phillips Curve is related to AS curve

• The Phillips curve shows the short-run combinations of
unemployment and inflation that arise as shifts in the aggregate
demand curve move the economy along the short-run aggregate
supply curve.
• The greater the aggregate demand for goods and services, the
greater is the economy’s output, and the higher is the overall price
level.
• A higher level of output results in a lower level of unemployment.

7
How the Phillips Curve is Related to Aggregate
Demand and Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation
Level Short-run Rate
aggregate (percent
supply per year)
6 B
106 B

102 A
High
A
aggregate demand 2
Low aggregate
Phillips curve
demand
0 7,500 8,000 Quantity 0 4 7 Unemployment
(unemployment (unemployment of Output (output is (output is Rate (percent)
is 7%) is 4%) 8,000) 7,500)

8
Equation for the Phillips Curve
The Phillips curve equation says  depends on
• expected inflation,  e.
• cyclical unemployment: the deviation of the actual rate of
unemployment from the natural rate
• supply shocks,  (Greek letter “nu”).

e n
     (u  u )  
where  > 0 is an exogenous constant.

9
The Phillips Curve and SRAS
SRAS: Y  Y   (P  P e )
Phillips curve:    e   (u  u n )  

• SRAS curve:
Output is related to unexpected movements in the price
level; Pe is fixed

• Phillips curve:
Unemployment is related to unexpected movements in the
inflation rate; e is fixed
10
Deriving the Phillips Curve from AS
(1) Y  Y   (P  P e )

(2) P  P e  (1  ) (Y Y )

(3) P  P e  (1  ) (Y Y )  

(4) (P  P1 )  ( P e  P1 )  (1  ) (Y Y )  

(5)    e  (1  ) (Y Y )  

(6) (1  ) (Y Y )    (u  u n )

(7)    e   (u  u n )  
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 Graphing the Phillips curve

In the short 
   e   (u  u n )  
run,
policymakers The short-
face a tradeoff  run Phillips
1
between  and u. curve
e 

u
un

12
Phillips Curve: Two important properties

π = πe – β (u – un) + υ

1. u < un only if π > πe

• It is possible to reduce unemployment rate only when actual
inflation is ‘unanticipated’ and more than expected inflation
• Monetary policy move must be unanticipated for there to be
any effect on real economy
• Actual inflation causes πe to be revised upward, making
monetary authority to go for even higher actual inflation to
reduce unemployment next time 13
Phillips Curve: Two important properties

π = πe – β (u – un) + υ

2. Higher expected inflation is passed one-for-one into

actual inflation
• If people anticipate higher inflation in future, they will try to
settle for a higher nominal wage
• Leads to higher price level and higher actual inflation

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