Chapter 11

Aggregate Supply and the Phillips Curve

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline
The Phillips Curve
Phillips Curve Analysis in the 1960s
Policy and Practice: The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s
The Friedman-Phelps Phillips Curve Analysis
The Phillips Curve After the 1960s
The Modern Phillips Curve
The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations
The Aggregate Supply Curve
Long-Run Aggregate Supply Curve
Short-Run Aggregate Supply Curve
Shifts in Aggregate Supply Curves
Shifts in the Long-Run Aggregate Supply Curve
Shifts in the Short-Run Aggregate Supply Curve

Chapter Overview and Teaching Tips

The last building block of the AD/AS framework is the aggregate supply curve. This chapter develops the
aggregate supply curve from Phillips curve analysis. To give students the intuition behind the Phillips
curve, the chapter starts by showing how Phillips curve analysis has evolved through time. The Policy and
Practice case, “The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s,” is a nice example to
discuss in class because it can show how incorrect theories can lead to mistakes in macroeconomic policy. An
advantage of proceeding with an historical approach to how ideas about the Phillips curve evolved over
time is that it naturally lends itself to a step-by-step process of development of the modern, expectations-
augmented Phillips curve, which makes it easier for students to understand it.

Once the modern, expectations-augmented Phillips curve is developed and students understand that it
implies that there is no long-run tradeoff between inflation and employment, it is fairly straightforward to
develop both the long-run and short-run aggregate supply curve, as is done in the chapter using Okun’s
Law. Then shifts in these curves are outlined, enabling students to be prepared for putting the aggregate-
demand analysis together with aggregate supply analysis to develop the full-fledged AD/AS analysis for
analyzing short-run economic fluctuations in the next chapter.

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◼ Answers to End of Chapter Review Questions and Problems

Answers to Review Questions
The Phillips Curve
1. The short-run Phillips curve describes a negative relationship between unemployment and inflation.
This seems to suggest that policy makers can “buy” lower unemployment if they are willing to pay
for it with higher inflation and that policies to reduce inflation will be costly because they will
increase unemployment.

2. According to the long-run Phillips curve, unemployment moves to a natural rate regardless of the rate
of inflation, so there is no long-run tradeoff between inflation and unemployment that policy makers
can exploit. This differs from the short-run Phillips curve analysis because in the long run workers
and firms care about real rather than nominal wages and incorporate expected inflation into their
work and hiring decisions. Because wages and prices are flexible in the long run, nominal wages
change in proportion to changes in inflation so that real wages remain unchanged. As a result there is
no movement of the unemployment rate away from its natural rate.

3. According to the expectations-augmented Phillips curve, the inflation rate depends on expected
inflation and the unemployment gap, which measures tightness in labor markets as the difference
between the actual and natural rates of unemployment. The inflation rate is higher with higher
expected inflation and a lower unemployment gap. Changes in expected inflation shift the short-run
Phillips curve upward (when expected inflation rises) or downward (when expected inflation falls).
Decreases in the unemployment gap (a tighter labor market) cause movements up along a given
short-run Phillips curve, and increases in the unemployment gap cause movements down along a
given short-run Phillips curve.

4. Adaptive expectations are formed by looking at past values of the variable being forecast. (Because
they look at the past, adaptive expectations sometimes are called backward-looking expectations.)
This means that expected inflation is based on past values of the inflation rate. This assumption is
justified by the view that inflation expectations are sticky and adjust slowly to past inflation changes
and by the fact that some wage and price contracts are backward looking and slow to adjust to
changes in expected inflation.

5. In modern Phillips curve analysis, the rate of inflation increases one-for-one with changes in expected
inflation and price shocks and moves inversely to the unemployment gap. Price shocks and changes
in expected inflation shift the short-run Phillips curve up or down and changes in the unemployment
gap cause movements along a given short-run Phillips curve.
The Aggregate Supply Curve

6. The aggregate supply curve shows the relationship between the total quantity of output supplied and
the inflation rate. In the long run, the amount of output an economy can produce is determined by its
labor, capital, and technology. Because none of these factors are related to the inflation rate, neither is
the economy’s potential output in the long run, and its long-run aggregate supply curve is, therefore, a
vertical line.
7. Okun’s Law relates the unemployment gap U − Un, where U is the unemployment rate and Un is the
natural rate of unemployment, to the output gap Y − YP, where Y is aggregate output and YP is the
economy’s potential output. The relationship between the two gaps is negative because when the
economy produces less than its potential output, the unemployment rate is greater than the natural
rate of unemployment. Combining Okun’s Law and Phillips curve analysis helps to derive the short-
run aggregate supply curve that relates total output supplied to the inflation rate because a negative

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short-run Phillips curve relationship between unemployment and inflation implies a positive relationship
between output and inflation.
8. When output increases relative to potential output, Y − YP increases. At the same time, according to
Okun’s Law, the unemployment rate is falling relative to the natural rate of unemployment, which
means that U − Un decreases. As the short-run Phillips curve shows, this tightening in the labor
market as output rises causes the inflation rate to rise. Therefore the short-run aggregate supply curve,
which shows the relationship between output and inflation, slopes upward because when the quantity
of output supplied increases, a decline in the unemployment gap causes the inflation rate to also
increase.
Shifts in Aggregate Supply Curves
9. Shifts in the long-run aggregate supply curve result from changes in the total quantities of capital and
labor in the economy and in the available technology. When any of these increase, the economy’s
potential output increases and the long-run aggregate supply curve shifts to the right. Decreases in
any of these factors shift the long-run aggregate supply curve to the left.

10. The short-run aggregate supply curve shifts upward when expected inflation increases, when positive
price shocks occur, or when there is a positive and persistent output gap that increases expected
inflation. Opposite changes in these factors shift the short-run aggregate supply curve downward.

Answers to Problems
The Phillips Curve
1.

According to the graph, there seems to be evidence in favor of a negative relationship between
inflation and unemployment during the 1960s in Canada.

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112 Mishkin • Macroeconomics: Policy and Practice, Second Edition

2.

According to the graph, there seems to be no relationship at all between inflation and unemployment
rates in Canada between 1970 and 2012. Higher inflation rates are not in general associated with lower
unemployment rates, as the Phillips curve predicts.

3. a. Substituting the values of expected inflation and the natural rate of unemployment yields the
following expression:  = 3 − 0.5(U − 5) . According to this expression, inflation rates are 3.5
percent, 3 percent, and 2.5 percent when unemployment rates are 4 percent, 5 percent, and 6
percent, respectively.
b. See graph:

c. If wages become more rigid, then the slope of the Phillips curve becomes flatter. Algebraically,
the  parameter decreases in absolute value to express the rigidity in wages. When prices become
less flexible, the same unemployment gap has a smaller effect on inflation rates, which translates
into a more horizontal Phillips curve.

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4. The modern Phillips curve allows for shifts in the Phillips curve that arise from price shocks. In this
case, the increase in oil prices is interpreted as a negative price shock that raises prices independently
of inflation expectations and labor market conditions. As a result, the Phillips curve shifted upwards,
as shown in the graph, from PC1 to PC2. As a result of the price shock, inflation was higher at every
unemployment rate.

The Aggregate Supply Curve

5. a. The percentage point change in unemployment is: % = − 0.75  (%Y). Therefore, a 1 percent
decrease in real GDP results in a 0.75 percentage point increase in unemployment.
b. The percentage point change in real GDP is: %Y = − 1.33% U. Therefore, a 2 percentage point
decrease in unemployment results in a 2.66 percent increase in real GDP.

6. a. First substitute the unemployment gap with Okun’s Law into the Phillips curve to get:
 =  e − 0.6  (− 0.75  (Y − Y P )) +  . According to the assumptions about inflation expectations,
no price shock and the level of potential output, the short-run aggregate supply curve is:
 = 3 + 0.45  (Y − 10).
b. Replacing the values for output into the above expression yields inflation rates of 2.1 percent, 3
percent, and 3.9 percent when output is $8, $10, and $12 trillion.

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7. The new short-run aggregate supply curve is:  = 3 + 0.45  (Y − 10) +  .

8. Okun’s Law held for these three countries. In all cases, a decrease in real GDP was matched with an
increase in unemployment. However, more rigid labor markets in Germany and France prevented a
higher response in unemployment. During 2008–2009, real GDP decreased by 2.5 percent and 5
percent in France and Germany, respectively. This was matched with an unemployment rate increase
of 2.5 and 0.5 percentage points in France and Germany, respectively. In the case of the United
States, a real GDP fall of 3.5 percent during the same period resulted in an increase of almost 5
percentage points in unemployment. As expected, France’s and Germany’s unemployment rate
sensitivities to the real GDP decrease were lower than in the United States. Economists argue that this
higher sensitivity of unemployment to real GDP in the United States is due to the ability of firms in
the United States to lay off workers more easily than in European countries. Note that in Germany
there was almost no change in unemployment, even if real GDP fell by around 5 percent. Although
this seems like a nice result, it is also true that because of labor market rigidities, unemployment is
usually higher in European countries than in the United States.
Shifts in Aggregate Supply Curves
9. a. The Internet reduced the amount of time and money spent looking for a job. It also allowed for an
increased flow of information between potential employees and employers (e.g., job descriptions,
resumes, and other valuable information are usually available online). This resulted in a decrease
in the natural rate of unemployment, as unemployed workers are matched with employment
opportunities quicker.

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b. Graphically, the long run aggregate supply curve shifts to the right:

10. If the public assumes that the current Fed officials are not that worried about inflation, expected inflation
will increase, shifting the short-run aggregate supply curve upward and to the left. There are periods
when Fed officials are in the difficult position of having to choose when to increase interest rates to
fight inflation when an economic recovery is just starting. Increasing interest rates too late would fuel
expectations about inflation, while increasing interest rates too soon will slow down the recovery. It
is quite difficult to make this decision, which is why most of the time the conduct of monetary policy
is more an art than a science.

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◼ Answers to Data Analysis Problems

1. a. See figure below. The scatterplot does seem to have a downward slope on inspection of the
figure, implying a tradeoff between inflation and unemployment as predicted by the Phillips
curve. This is confirmed in part (b) using regression analysis. The most recent unemployment
and inflation data for 2013:Q1 are 7.7 percent and 1.2 percent, respectively, and shown as the
larger square in the scatterplot.
b. The fitted line equation is Inflation = –0.2398UR + 3.6699, with an R² = 0.238. Thus, the
negative slope of the fitted line indicates a tradeoff between inflation and unemployment.
i. According to the fitted regression, a decrease in unemployment of 1 percentage point would
lead to an increase in inflation of 0.23 percentage points. The most current unemployment
and inflation figures for 2013:Q1 are 7.7 percent and 1.2 percent, respectively. Thus, this
hypothetical change would lead to a 6.7 percent unemployment rate, and a 1.43 percent
inflation rate.
ii. The estimated Phillips Curve here has a modest amount of predictive power at best. An R2 of
0.24 indicates that this simple Phillips curve can only explain approximately a quarter of the
variation between the two variables; the other 75 percent is unexplained in this simple model.
Accounting for movements in inflation expectations, changes in the natural rate, and
exogenous price shocks would significantly sharpen the apparent relationship between
movements in the unemployment rate and inflation rate.

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2. a. Positive output gaps: 2000:Q1 to 2001:Q2; 2005:Q1 to 2007:Q4. Negative output gaps: 2001:Q3
to 2004:Q4; 2008:Q1 to 2013:Q1
b. See table below.
c. For the most part, the table does fit the view of an accelerationist Phillips curve. In periods when
output is sustained above potential (positive output gaps), the change in inflation is positive over
those periods. The recent negative output gaps do not hold as much to form, however. The
2001:Q3 to 2004:Q4 period is an exception, with output declining slightly, while inflation
increased through the period. However, the period encompassing the financial crisis from 2008 to
the present (2013:Q1) showed significant declines in output below potential, for a significant
amount of time. This is entirely consistent with an accelerationist view because inflation fell on
net over that time by a relatively large amount. More generally, the larger output gaps, positive or
negative, produce a bigger change in inflation over the period, again consistent with an
accelerationist Phillips curve.
Average Output Gap Change in Inflation
Positive Output Gaps
2000:Q1 to 2001:Q2 2.22 0.80
2005:Q1 to 2007:Q4 0.46 0.70

Negative Output Gaps

2001:Q3 to 2004:Q4 –0.88 1.20
2008:Q1 to 2013:Q1 –5.56 –2.20

3. a. See regression output below, for 2000:Q1 to 2013:Q1.

b. The results are entirely consistent with a short-run aggregate supply curve: The slope of the curve
is positive, with an estimated (γ) coefficient of 0.15 meaning if the output gap rises by 1
percentage point, inflation will rise by 0.15 percentage points. The coefficient on inflation
expectations is very close to one, at 0.94; thus, if inflation expectations rise by 1 percentage
point, inflation overall will rise by 0.94 percentage points, almost all of the increase in inflation
expectations.
c. The estimated short-run aggregate supply curve has very good predictive power, with an overall
R2 of 0.63. Thus, 63 percent of the variation in inflation can be explained through variation in
output gap and inflation expectation movements. It is not surprising that this more sophisticated
aggregate supply curve has a better fit to the data than the previous problem because the simple
Phillips curve didn’t take account of changes in inflation expectations, or movements in potential
output (via the natural rate of unemployment), both of which can shift this relationship and
confound the stability between inflation and output (or unemployment).
d. In 2013:Q1, the output gap was –5.8 percent; thus, if policy makers were to close this output gap,
the short-run aggregate supply curve would predict a 0.15 × (5.8%) = 0.87 percentage point
increase in inflation as a result.
Regression Statistics
Multiple R 0.79263838
R Square 0.62827561
Adjusted R Square 0.61340663
Standard Error 0.58732954
Observations 53

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118 Mishkin • Macroeconomics: Policy and Practice, Second Edition

ANOVA
df SS MS F Significance F
Regression 2 29.15162874 14.57581 42.25413 1.80105E-11
Residual 50 17.24779922 0.344956
Total 52 46.39942796

Standard
Coefficients Error t Stat P-value
Intercept –0.39254458 0.414871826 –0.94618 0.348606
Inflation Expectations 0.93739884 0.132581164 7.070377 4.66E-09
Output Gap 0.14630438 0.025226888 5.799541 4.48E-07

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Policy and Practice: The Phillips Curve Tradeoff and
Macroeconomic Policy in the 1960s
Data Sources
Bureau of Labor Statistics: http://www.bls.gov/cps/. For unemployment rate data, click on the “10 years of
historical data” icon (the green dinosaur) and select 1959 to 1969 to get data for the period in question.
http://data.bls.gov/cgi-bin/surveymost?cu .For inflation data, click on “U.S. All items, 1982-84=100,”,then
“retrieve data” and select 1959 to 1969 to get data for the period in question.
Related Article
Hoover, Kevin D. “The Phillips Curve”: http://www.econlib.org/library/Enc/PhillipsCurve.html. This article
defines the concept of the Phillips curve and reviews later additions to the theory made by other authors.
Discussion Question
During the 2000–2010 period, inflation rates in the United States fluctuated around a fairly low average of
2.5 percent annual rate, while the unemployment rate increased sharply at the end of the period (from around
5 percent in the early 2000s to almost 10 percent in 2009). Would this data be consistent with the Philips
curve concept?
Answer: According to the Phillips curve, fairly constant inflation rates should have been matched with
fairly constant unemployment rates (corresponding to a point in a given Phillips curve). The increase in the
unemployment rate at the end of the period should have been matched with a decrease in inflation rates.
This decade adds evidence to the hypothesis that the Phillips curve (in its more basic form) should be
reformulated to explain this data. This will happen later in the text.

B. For Information About Okun’s Law

Data Sources
Bureau of Labor Statistics: http://www.bls.gov/cps/. For unemployment rate data, click on the “10 years of
historical data” icon (the green dinosaur) and select 1960 to 2013 to get data used for Figure 11.4.
Federal Reserve Bank of St. Louis data base (FRED):
http://research.stlouisfed.org/fred2/graph/?id=GDPC1 . Click on “Edit Graph” and change the years to
1960–2013, and select “Percent Change” in Units to get the data used in Figure 11.4; You can download
the dataset by clicking “Download Data in Graph.”

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Related Article
Okun, Arthur M., “Potential GNP: Its Measurement and Significance”:
http://cowles.econ.yale.edu/P/cp/p01b/p0190.pdf. Here you can find the paper referenced in the text.
Discussion Question
During the second semester of 2009 and the first semester of 2010, the GDP growth rate became positive.
However, percentage changes in the GDP growth rate were not matched by half percentage point decreases
in the unemployment rate during that period. Would this suggest that Okun’s Law is no longer valid?
Answer: Even if a percentage point increase in the GDP growth rate was not matched with half a percentage
point decrease in the unemployment rate during 2009III–2010II (roman numbers denote quarters), this does
not mean that Okun’s Law is no longer holding. One of the problems with severe recessions (like the one
experienced during 2007–2009) is that the average duration of unemployment increases. This results in
workers losing skills, making it more difficult for firms to find a good match whenever they decide to start
hiring again. Other explanations to the slow decrease in unemployment cite the extension to unemployment
insurance, as noted in this article:
http://online.wsj.com/article/SB10001424052748703959704575454431457720188.html?
KEYWORDS=jobless+recovery.

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