Aggregate Supply and the

Phillips Curve
 AD/AS and the Phillips Curve
• The AD/AS Model shows the short-run relationship
between price level and employment. As price
level rises, employment increases (point A to point B
on AS curve).
• The Phillips curve shows the short-run relationship
between inflation and unemployment. As price
level rises, unemployment decreases (point A to point
B on Phillips curve).
• Movement up along the supply curve is mirrored
by movement up along the Phillips curve.
 How the Phillips Curve is Related to the Model
of Aggregate Demand and Aggregate Supply
in the Short-run
(a) The Model of AD and AS (b) The Phillips Curve

Price Level SRAS Inflation Rate

(% per year)
106 B B
6
102 High AD
A
2 A
Low AD Phillips curve
0 7,500 8,000 Output 0 4 7 Unemployment
Rate (%)
 Shifts in the Phillips Curve
 The short-run Phillips curve shifts because of
shocks to aggregate supply.
 A negative supply shock is shown by a leftward
shift of AS (AS1 to AS2) and an upward shift of the
Phillips curve (PC1 to PC2). The result is higher
prices and higher unemployment)
 A positive supply shock would move AS to the
right and shift the Phillips curve downward
(lower prices and lower unemployment)
 An Adverse Shock to Aggregate Supply...
(a) The Model of Aggregate (b) The Phillips Curve
Demand and Aggregate Supply
3. …and raises the 4. …creating a less
Price Inflation favorable tradeoff
Level price level… Rate between unemployment
AS2 Aggregate and inflation.
supply, AS1

B
P2 B 1. An adverse
shift in aggregate A
A supply…
P1 PC2
Aggregate
demand Phillips curve, PC1
0 Y2 Y1 Quantity of 0 Unemployment Rate
Output
2. …lowers output…
 The Long Run Phillips Curve
• The Long Run Phillips Curve illustrates the Natural
Rate of Unemployment
• Changes in price level do not affect the LRPC, but
the LRPC can change (shift) if there are changes in:
– Minimum wage
– Collective bargaining laws
– Unemployment insurance
– Job training programs
– Job search assistance
The Long-Run Phillips Curve...
Inflation LRPC1 LRPC2
Rate

0 Natural rate of Unemployment

unemployment Rate
 Expectations and the
Short-Run Phillips Curve
 Expected inflation measures how much
people expect the overall price level to
change.
 Expected inflation is the point on the Short-
run Phillips Curve that intersects the LRPC
(point A)
Changes in the expected rate of inflation
affect the short-run trade-off between
inflation and unemployment and shift the
short-run Phillips curve
 Expected Inflation
Long-run
Inflation Phillips Curve
Rate

6% B

Expected Rate of
Inflation
4% A

C
Short-run
Phillips curve

0 Natural Rate of Unemployment

Unemployment/NAIRU Rate
 Inflation and Unemployment in the Short-run

• If actual inflation is higher (4%) than expected

inflation (6%), then unemployment decreases.
• This is shown by movement upward and along
a stable Phillips Curve (point A to point B).
• If actual inflation is lower than expected
inflation (2% instead of 4%), then unemployment
increases, movement down along the PC (Point
A to point C).
 Expected Inflation & Actual Inflation
Long-run
Inflation Phillips Curve
Rate
Actual Rate of
Inflation
6% B

Expected Rate of
Inflation
4% A

C
2%

0 Natural Rate of Unemployment

Unemployment/NAIRU Rate
Expectations and the SRPC in the Long-Run
 In the long run, expected inflation adjusts to
changes in actual inflation.
• --This is shown by a shift of the short-run
Phillips Curve
• --If inflationary expectations are now higher
the curve shifts right (PC1 to PC2).
• --If inflationary expectations are now lower
the curve shifts left (PC2 to PC1).
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

How Expected Inflation Shifts the Short-Run

Phillips Curve...
Inflation Long-run
Rate Phillips curve
2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
B C curve shifts to the right.

1. Expansionary SRPC 2
policy moves
the economy up A
along the short-
run Phillips
SRPC1
curve...
0 Natural rate of Unemployment
unemployment/NAIRU Rate
Deflation
•Deflation-
prices drop as
a result of a
deep
recession
•Zero Bound-
What would
happen if the
expected rate
of inflation is -
2% and the
current
interest rate is
0%?
•Liquidity Trap