Prof.

Pami Dua
Department of Economics
Delhi School of Economics

Course 004: Macroeconomic Theory

Handout No. 1
Phillips Curve and Lucas Supply Function-A Review

 AD-AS
 Phillips Curve
 Lucas Supply Function

REFERENCE: FRISCH
Link with AD-AS
 Inflation is a sustained upward movement in the price level.
 A sustained rise in inflation requires a continuous increase in aggregate demand.
 A continuous increase in demand pulls the price level up continuously.

Effect of an increase in AD

P
AS2 (w2)
AS1 (w1)

P3
E3
P2 E2

P1 E1

AD3
AD2
AD1
YF Y2 Y

Assume that short-run wages are rigid due to wage contracts (or assume prices adjust slowly).
These wage contracts will expire after a stipulated period of time and wages will be
renegotiated. Higher price level puts upward pressure on the nominal wage rate to rise.
Therefore, AS1 curve shifts up and Y falls below Y2. The economy moves from E1 to E2 to E3.

Course 004: Macroeconomic Theory Handout 1

 Prof. Pami Dua
Department of Economics
Delhi School of Economics

What must happen to prevent the level of output from declining?

The AD schedule must shift upwards by exactly the same amount as the supply schedule. But
the price level again increases and there will again be an upward pressure on the nominal wage
rate and the contracts are renegotiated.
A continuous increase in AD⇒the economy will move straight upward along the path depicted
by the arrows. This can be translated into the rate of inflation diagram shown below.

Rate of
SP
inflation
𝑃𝑃𝑒𝑒̇ 3%
E2
0%
E1

YF Y1 Y

The maintenance of a higher level of output requires a continuous increase in AD and in the
price level as depicted by the arrows. The same process of continuous inflation in the 2nd
diagram is illustrated by the single point E2 where each period the rate of change of the price
level is 3%.
The upward sloping line in the 2nd diagram is called the SP line (short-run Phillips curve). It
shows that to maintain real output above the natural level, aggregate demand must be raised
continuously to create continuous inflation.
All points to the right of YF depict the characteristic that the economy is not in a long-run
equilibrium because the price level is continuously racing ahead of the nominal wage rate. This
implies that the wage contracts have an expected rate of inflation to be zero. People do not
anticipate further inflation when they negotiate labour contracts.

Rate of SP (𝑃𝑃𝑒𝑒̇ = 0)
inflation 3%
𝑃𝑃𝑒𝑒̇ E2
0%
E1

YF Y2 Y

Course 004: Macroeconomic Theory Handout 1

 Prof. Pami Dua
Department of Economics
Delhi School of Economics

Since the position of the SP curve critically depends on the expectations, this gives us the
expectations augmented Phillips curve. If people correctly expect the 3% inflation rate, the SP
curve would shift up by 3%.

SP2 (𝑃𝑃𝑒𝑒̇ = 3%)

Rate of SP1 (𝑃𝑃𝑒𝑒̇ = 0%)

inflation
3%
𝑃𝑃𝑒𝑒̇
0%

YF Y

The vertical line passing through YF shows all the possible positions of long-run equilibrium
where the actual and expected inflation rates are equal.

Generally, the Phillips curve is depicted with inflation vs. unemployment.

The Short-run and Long-run Phillips Curve

In the late 60s and early 70s, Friedman and Phelps questioned the stability of the PC under
changing inflationary expectations. The choice of a point along the PC produces a certain rate
of inflation. After an adjustment period, this produces a new expected rate of inflation and
causes the PC to shift. That is, there is no long-run trade-off between unemployment and
inflation.

Each PC is defined for a particular expected inflation rate 𝑃𝑃𝑒𝑒̇ or 𝜋𝜋𝑒𝑒 .

Therefore, PC can be written as 𝑃𝑃̇ = 𝑓𝑓(𝑈𝑈) + 𝑃𝑃𝑒𝑒̇

Course 004: Macroeconomic Theory Handout 1

 Prof. Pami Dua
Department of Economics
Delhi School of Economics

Price inflation 𝑃𝑃̇

2%

1%
𝑃𝑃𝑒𝑒̇ = 2%

0 Un 𝑃𝑃𝑒𝑒̇ = 1% Unemployment rate

𝑃𝑃𝑒𝑒̇ = 0%

A change in the expected rate of inflation shifts the PC⇒an increase shifts the curve up and a
decrease shifts the curve towards the origin.
Now, suppose that there is a monetary expansion which leads to an increase in the nominal
aggregate demand then it will lead to a decline in the unemployment rate below the natural
rate.

Price inflation 𝑃𝑃̇

0 Un Unemployment rate
𝑃𝑃𝑒𝑒 =̇ 0%

Friedman’s Hypothesis
Suppose this produces an increase in prices and wages. Also, suppose workers and employers
experience money illusion.
Workers-initially interpret this as a rise in their real wages because they still anticipate constant
prices and are, therefore, willing to offer more labour.
Employers-initially interpret a rise in the price of their products as an increase in the relative
price. This is interpreted as a decrease in the real wage rate and therefore, they are willing to
hire more labour.
Disequilibrium- realized rate of change in prices and wages do not correspond to the expected
values of these variables.

Course 004: Macroeconomic Theory Handout 1

 Prof. Pami Dua
Department of Economics
Delhi School of Economics

A learning process starts and leads to a realization that prices generally have risen
simultaneously with the money wage along with the price of the firm’s product. (In the labour
market increase in money wages leads to a decrease in the frictional unemployment due to
decrease in the number of quits and decrease in the average duration of job search)
Therefore, economic agents raise their anticipated rate of inflation. This implies that the
original real effect of the increase in aggregate demand on output and employment, therefore,
tends to disappear.

Long-run Phillips Curve

Inflation

𝑃𝑃𝑒𝑒̇ = 0

C
3%
B

A
4% Un
Unemployment

A permanent reduction in the rate of unemployment below the natural rate requires an
accelerating rate of inflation.

Course 004: Macroeconomic Theory Handout 1

 Prof. Pami Dua
Department of Economics
Delhi School of Economics

Long-run Phillips Curve

Inflation

PC3
PC2
PC1
D E
5%

C
3%
B

𝑃𝑃𝑒𝑒̇ = 5%
A
4% Un Unemployment
𝑃𝑃𝑒𝑒̇ = 3%
𝑃𝑃𝑒𝑒̇ = 0%

Assume that the Phillips Curve PC1 is valid and that the economic system is at position A. At
this point the natural rate of unemployment is Un=5.5% and the actual rate of inflation equals
the anticipated rate, which is zero. Through a policy of expanding the aggregate demand, the
government reduces the unemployment rate to 4%, so that, according to the Phillips curve PC1,
an inflation rate of 3% results (point B).
This implies:
-actual real wage < expected real wage
-actual relative price < expected relative price
The learning process starts, leading to an upward shift in Phillips curve to PC2. The
Phillips curve PC2 is valid under the assumption that the expected rate of inflation is 3% (point
C corresponds to Un). To hold the unemployment rate below the natural rate requires repeated
increases in aggregate demand to produce an actual rate of inflation that continuously exceeds
the anticipated rate.
A permanent reduction in the unemployment rate below the level of the natural rate
therefore produces an accelerating rate of inflation. The long-run Phillips curve will be vertical
because when actual inflation rate is equal to the expected inflation rate, output produced will
always remain at natural rate level.

Equation for Phillips Curve:

Course 004: Macroeconomic Theory Handout 1

 Prof. Pami Dua
Department of Economics
Delhi School of Economics

𝑃𝑃𝑡𝑡̇ = 𝑓𝑓(𝑈𝑈𝑡𝑡 ) + 𝑃𝑃̇𝑡𝑡𝑒𝑒

Introduce a stochastic disturbance term to get,

𝑃𝑃𝑡𝑡̇ = 𝜃𝜃(𝑈𝑈𝑡𝑡 − 𝑈𝑈𝑛𝑛 ) + 𝑃𝑃̇𝑡𝑡𝑒𝑒 + 𝜀𝜀𝑡𝑡 , 𝜃𝜃 < 0

Where 𝑃𝑃𝑡𝑡̇ = 𝑃𝑃𝑡𝑡 − 𝑃𝑃𝑡𝑡−1 and 𝑃𝑃̇𝑡𝑡𝑒𝑒 = 𝑒𝑒

𝑡𝑡−1𝑃𝑃𝑡𝑡 − 𝑃𝑃𝑡𝑡−1 (price level is measured in logs)
If 𝑈𝑈𝑡𝑡 − 𝑈𝑈𝑛𝑛 < 0, there is excess demand and unemployment rate is below the natural rate, the
rate of inflation is increasing relative to the expected rate.
If 𝑈𝑈𝑡𝑡 − 𝑈𝑈𝑛𝑛 > 0, unemployment rate is above the natural rate, the rate of inflation is falling
relative to the expected rate.
This can be written as

𝑃𝑃𝑡𝑡 − 𝑃𝑃𝑡𝑡−1 = 𝑃𝑃̇ = (𝑌𝑌𝑡𝑡 − 𝑌𝑌�) + 𝑃𝑃𝑡𝑡𝑒𝑒̇ + 𝑣𝑣𝑡𝑡

What determines expectations?
In Rational Expectations macro models, AS function is specified as the Lucas Supply
Function.

𝑌𝑌𝑡𝑡 = 𝑌𝑌� + 𝛽𝛽�𝑃𝑃𝑡𝑡 − 𝑡𝑡−1𝑃𝑃𝑡𝑡𝑒𝑒 � + 𝜇𝜇𝑡𝑡

Where 𝑌𝑌𝑡𝑡 is the output in logs; 𝑌𝑌� (earlier denoted as YF) is the natural rate output level in logs
and 𝜇𝜇𝑡𝑡 is the random supply disturbance (white noise).
Therefore, deviation in output from its natural rate level depends upon
(i) Error in predicting the current price level
(ii) Current supply shock
Lucas Supply Function can be viewed as an inverse form of the Phillips curve.
The usual Expectations Augmented Phillips curve in log-linear form can be specified as:

𝑃𝑃𝑡𝑡 − 𝑃𝑃𝑡𝑡−1 = Π(𝑌𝑌𝑡𝑡 − 𝑌𝑌�) + � 𝑡𝑡−1𝑃𝑃𝑡𝑡𝑒𝑒 − 𝑃𝑃𝑡𝑡−1 � + 𝑣𝑣𝑡𝑡

𝑃𝑃𝑡𝑡 − 𝑃𝑃𝑡𝑡−1 = 𝑃𝑃𝑡𝑡̇ is the actual rate of inflation over the period (t-1,t).

Add 𝑃𝑃𝑡𝑡−1 to both sides, we get the Inverse Phillips Curve

𝑃𝑃𝑡𝑡 − 𝑡𝑡−1𝑃𝑃𝑡𝑡𝑒𝑒 = Π(𝑌𝑌𝑡𝑡 − 𝑌𝑌�) + 𝑣𝑣𝑡𝑡

Rearranging, we get the Lucas supply function

𝑌𝑌𝑡𝑡 = 𝑌𝑌� + 𝛽𝛽�𝑃𝑃𝑡𝑡 − 𝑡𝑡−1𝑃𝑃𝑡𝑡𝑒𝑒 � + 𝜀𝜀𝑡𝑡

This and the expectation formation will be discussed in detail later.

Course 004: Macroeconomic Theory Handout 1