Planning and

Macroeconomic Policies
Noha Nagi Elboghdadly
ESPS Alexandria University
First Semester 2020/2021

Noha Nagi Planning and Macroeconomic Policies

Lecture 5: Aggregate Supply and the Phillips Curve
• In this lecture, we will

➢Use the Phillips curve and Okuns law to derive SRAS.

➢Identify the factors that shift the SRAS curve

This lecture corresponds to Ch.11 in ‘Macroeconomics Policy and Practices by Frederic S. Mishkin, 2nd edition, 2014.’.

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Introduction
• AS show the relationship between inflation rate and aggregate output.
• Long-run Aggregate supply is vertical ( no relation between inflation rate and
aggregate output in the long-run. What about in the Short-run??

• In the short-run, there is a positive relationship between inflation (п) and

aggregate output, Y.
• Can be derived from the relationship between inflation (п) and unemployment,
U.
• The relationship between inflation and unemployment is presented by Phillips
curve

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Introduction
• The history of Phillips curve goes back to 1958.
• The Phillips curve shows the negative relationship between
unemployment and inflation.
• The Philips curve quickly became the basis for the discussion of
macroeconomic policy.
• Policy faced a tradeoff: Lower unemployment could be achieved, but
only at the cost of higher inflation.
• The Philips curve provide the intuition for the aggregate supply curve.
• We will start by explaining Phillips curve, then we derive the SRAS
curve.
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Phillips Curve
• The Modern Phillips Curve (SRPC) shows that there are three factors
identify inflation:
(1) expectations of inflation,
(2) Unemployment gap  = e − (U − Un ) + 
(3) price (supply) shocks. where
 = inflation
e = expected inflation
 = sensitivity of  to unemployment gap (U − Un )
Every point on the SRPC represents a U = unemployment
combination of unemployment and Un = natural rate of unemployment
inflation that an economy might  = price (supply shock)
experience given current expectations
about inflation and a given price shock

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Phillips Curve Analysis
1) Tradeoff between inflation and unemployment

 = e − (U − Un ) + 

When U  U n Labor markets is tight (Excess demand for labor or

Low unemployment shortage of workers)
rate

Firms raise wages to attract workers

Firms raise their prices at a more rapid rate (pass through costs)

Inflation increases

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Phillips Curve Analysis
Inflation rate, п

A decrease in
unemployment rate
(U<Un) leads to PC
movement along the
PC (1 to 2), raising
the inflation rate. 3.5% B

A
2%
An increase in 1.5% D
unemployment rate
(U>Un) leads to
movement along the Unemployment
U=4% Un=5% U=7%
PC (1 to 3), reducing rate, U
the inflation rate.

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Phillips Curve Analysis
• The short-run Phillips curve implies wages are prices are sticky.
• The more flexible wages and prices are, the more inflation responds to deviations
of unemployment from natural rate.

• That is, the more flexible wages and prices imply that the absolute value of ω is
higher ( i.e. the PC is steeper)

• If wages and prices are completely flexible, ω becomes so large and the PC is
vertical (long-run Phillips Curve LRPC)

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Phillips Curve Analysis
2) Expected Inflation
 = e − (U − Un ) + 

• Workers and firms care about wages in real terms—that is, in terms of the
goods and services that wages can buy.
• When workers expect the price level to be rising, they will adjust nominal
wages upward one-for-one with the rise in expected inflation, so that the real
wage rate does not decrease.
• Because wages are the most important cost of producing goods and services,
overall inflation will also rise one-for- one with increases in expected inflation.

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Phillips Curve Analysis
How firms and household form expectation about inflation?
• Adaptive (Backward-Looking) Expectations A simple way is to assume that they
do so by looking at past inflation.
e = −1
where  −1 = inflation rate in the previous period

 = −1 − (U − Un ) + 

• This assumption implies that inflation expectation adjust slowly as it depends on

past inflation.

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Phillips Curve Analysis
Inflation rate, п

PC2
If inflation rises from 2%
to 3.5% : Movement along PC1
C
the PC. 5%
Then, expected inflation B
3.5%
will increase and hence
shift the PC upwards . A
2%

U=4% Un=5% Unemployment

rate, U

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Phillips Curve Analysis
3) Price (supply) shocks
 = e − (U − Un ) + 

• Supply Shocks: are shocks to supply that change the amount of output an
economy can produce from the same amount of capital and labor. Ex: rise in oil
prices in 1973 and 1979.
• These supply shocks translate into price shocks, that is, shifts in inflation that are
independent of tightness of labor market or expected inflation.
• Price shocks could also result from a rise in import prices or from cost-push
shocks.

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Short-Run Aggregate Supply (SRAS) Curve
• We can translate the modern Phillips curve into the SRAS curve by
replacing the unemployment gap (U − U ) with the output gap (Y − Y ) .
n
P

• This transformation can be done using Okun’s law:

describes the relationship between unemployment gap and the output
gap
• Okun’s law states that a one percentage point increase in output leads
to one-half percentage point decline in unemployment

U − U n = −0.5  (Y − Y P )

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Derivation of SRAS
• Modern Phillips curve is given by:
 = e − (U − Un ) + 
• Using Okun’s law, we can write the above equation as:

 = e + 0.5 (Y − Y P ) + 

• Replacing 0.5ω by, we have

 = e + (Y − Y P ) +  SRAS
where γ measures sensitivity of inflation to output gap.
• γ also represents how steep the AS is ( based on the underlying price/wage
stickiness).

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SRAS Curve
Inflation rate, п
LRAS
If (Y<YP) leads to
movement along the
SRAS (1 to 2), SRAS
reducing inflation
rate.
3
4%
1
2%
If (Y>YP) leads to
movement along the 1.5% 2
SRAS (1 to 3), raising
inflation rate. Aggregate
Y=9 YP=10 Y=11
Output, U

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SRAS Curve
• The short-run aggregate supply curve assumes sticky wages and prices because it
is derived from the short-run Phillips curve.

• In the SRAS, the more flexible wages and prices, the more inflation responds to
the output gap. This implies that the value of γ is higher (i.e. SRAS is steeper).

• When wages and prices are completely flexible, γ becomes so large and the SRAS
becomes vertical, i.e. identical to the LRAS curve.

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Shifts in the SRAS
Factors that shift the SRAS
1) Expected Inflation
A rise in expected inflation causes the short-run aggregate supply curve to shift
upward and to the left. Conversely, a decline in expected inflation causes the short-
run aggregate supply curve to shift down and to the right. The larger is the change
in expected inflation, the larger is the shift.

2) Price Shocks
Unfavorable supply shocks that drive up prices (e.g. sudden increase in energy
prices) cause the short-run aggregate supply curve to shift up and to the left while
favorable supply shocks that lower prices cause the short-run aggregate supply
curve to shift down and to the right.
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Shifts in the SRAS

Noha Nagi Planning and Macroeconomic Policies