phillips curve, monetary policy - denton isd · the phillips curve •in a 1958 paper, new zealand...
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AP Macro Phillips Curve, Monetary Policy
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The Phillips Curve
(hypothetical example)
tt%
u%
PC
4%
2%
7% 5%
.
. . .
.
. .
Note: Inflation Expectations are held constant
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The Phillips Curve
• In a 1958 paper, New Zealand born economist,
A.W. Phillips published the results of his research
on the historical relationship between the
unemployment rate (u%) and the rate of inflation
(tt%) in Great Britain.
• His research indicated a stable inverse
relationship between the u% and the tt%. As u%↓,
tt%↑ ; and as u%↑, tt%↓.
• The implication of this relationship was that policy
makers could exploit the trade-off and reduce u%
at the cost of increased tt%.
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Trouble for the Phillips Curve
• In the 1970’s the U.S. experienced concurrent high
u% & tt%, = stagflation.
• 1976 American Nobel Prize economist Milton
Friedman saw stagflation as disproof of the stable
PC.
• Instead of a trade-off between u% & tt%,
Friedman and 2006 Nobel Prize recipient Edmund
Phelps believed that Un was independent of the
tt%. This independent relationship is now referred to as the Long-Run Phillips Curve.
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1970’s Phillips Curve
π%
u%
PC
4%
2%
7% 5%
.
. . .
.
. .
. .
. .
.
.
. .
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The Long-Run Phillips Curve
π%
u%
LRPC
un%
Note: Natural rate of unemployment is held constant
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Un defined
The natural rate of unemployment (NRU) is defined as the equilibrium
rate of unemployment i.e. the rate of unemployment where real wages
have found their free market level
It is where the aggregate supply of labor is in balance with the
aggregate demand for labor.
At the natural rate, all those wanting to work at the prevailing real wage
rate have found employment and there is no involuntary unemployment
There remains some voluntary unemployment as some people remain
out of a job searching for work offering higher real wages or better
conditions.
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The Long-Run Phillips Curve (LRPC)
• b/c the LRPC exists at the un, structural changes
in the economy that affect un will also cause the
LRPC to shift.
• In order to reduce the Un, structural policies
must be directed towards an economy's supply
side.
• Increases in un will shift LRPC
• Decreases in un will shift LRPC
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Phillips Curve – LR and SR
Inflation
rate
LRPC
Unemployment
rate
SRPC (assumes 4 % expected inflation at each UR)
Natural rate
of
unemployment
2%
4%
SRPC (assumes 2% expected inflation at each UR)
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Summary • There is a short-run trade off between u% & π%. This is
referred to as a short-run Phillips Curve (SRPC)
• In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)
• The LRPC exists at the natural rate of unemployment (un). – un ↑ .: LRPC
– un ↓ .: LRPC
• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC – AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
– AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC
• Δ Inflationary Expectations, Δ Input Prices, Δ Productivity,
Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC – SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC
– SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC
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SRPC (tt^ %)
LRPC
tt %
uN%
A
B C
tt1 %
u%
SRPC (tt1^ %)
In the long-run, the inflation rate at B (π1 %)
becomes the new expected
inflation rate (π1^%), and the
economy returns to the
natural rate of unemployment
(point C).
Reconciling the LRPC and SRPC
tt%
u%
Assume that either
the government or
the central bank
enacts an
expansionary policy to reduce
the
unemployment
rate below its
natural rate at
point A.
In the short-run,
assuming the
policy is
successful,
inflation occurs
and
unemployment
decreases as
the economy
moves from A
to B.
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SRPC (π^ %)
LRPC
π %
uN%
A
B C π1 %
u%
SRPC (π1^ %)
In the long-run, the inflation rate at B (π1 %)
becomes the new expected
inflation rate (π1^%), and the
economy, once again,
returns to the natural rate of
unemployment (point C).
Reconciling the LRPC and SRPC
π%
u%
Now assume that
either the government
or the central bank
enacts a
Contractionary policy to reduce
inflation from it’s
current rate at point A
In the short-run, assuming the
policy is successful, disinflation
occurs and unemployment
increases as the economy
moves from A to B.
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Relating Phillips Curve to
AS/AD • Changes in the AS/AD model can also be seen in
the Phillips Curves
• An easy way to understand how changes in the AS/AD model affect the Phillips Curve is to think of the two sets of graphs as mirror images.
• NOTE: The 2 models are not equivalent. The AS/AD model is static, but the Phillips Curve includes change over time. Whereas AS/AD shows one time changes in the price-level as inflation or deflation, The Phillips curve illustrates continuous change in the price-level as either increased inflation or disinflation.
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Increase in AD = Up/left
movement along SRPC
C↑, IG↑, G↑ and/or XN↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
GDPR
PL
AD
SRAS LRAS
YF
P
Y
AD1
P1
SRPC
π
u
π%
u% un
π 1
. .
. .
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Decrease in AD = Down/right
along SRPC
C↓, IG↓, G↓ and/or XN↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC
GDPR
PL
AD
SRAS
LRAS
YF
P
Y
AD1
P1
u%
π%
SRPC
un
π
u
π1
. . . .
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SRAS = SRPC
Inflationary Expectations↓, Input Prices↓, Productivity↑,
Business Taxes↓, and/or Deregulation .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC (Disinflation)
GDPR
PL
AD
SRAS
LRAS
YF
P
Y
SRAS1
P1
u%
π% SRPC
LRPC
un
π
u
SRPC1
π1
. . . .
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SRAS = SRPC
Inflationary Expectations↑, Input Prices↑, Productivity↓,
Business Taxes↑, and/or Increased Regulation .: SRAS .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC (Stagflation)
GDPR
PL
AD
SRAS
LRAS
YF
P
Y1
SRAS1
P1
u%
π%
SRPC
LRPC
un
π
u1
SRPC1
π 1 . . . .
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Phillips Curve Review
• SRAS increases = shift SRPC right
• SRAS decreases = shift SRPC left
• AD increases = movement up and left
• AD decreases = movement down and right
• Increases in un will shift LRPC
• Decreases in un will shift LRPC
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Money Market
NIR
Q1 Q
MD
MS
i1
•MS – affected by actions of the
Federal Reserve
•MD –
•Transaction demand
determined by GDP
•Asset demand
determined by NIR