Aggregate Supply and th

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Phillips Curve
Chapter #6

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 Introduction
• Further develop the AS side of the economy; examine the
dynamic adjustment process from the short run to the long
run
– The price-output relationship is based upon links between
wages, prices, employment, and output
 link between unemployment and inflation = Phillips Curve
– Translate between unemployment and output, inflation and
price changes
• Introduce role of price and inflation expectations, and the
“rational expectations revolution”
• NOTE: theory of AS is the least settled area in macro
– Don’t fully understand why W and P are slow to adjust, but
offer several theories
– All modern models differ in starting point, but reach the same
conclusion: SRAS is flat, LRAS is vertical

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 The Phillips Curve
• In 1958 A.W. Phillips
published a study of wage
behavior in the U.K. between
1861 and 1957
• The main findings are
summarized in Figure 6.2
 There is an inverse
relationship between the rate
of unemployment and the
rate of increase in money
wages
 From a policymaker’s
perspective, there is a
tradeoff between wage
inflation and unemployment

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 The Phillips Curve
•If * represents the natural rate of unemployment, the simple PC is
defined as:

Wt 1  Wt
gw 
Wt
g w   (    * )

where  measures the responsiveness of wages to unemployment

–Wages are falling when  > * and rising when  < *

–( - *) is called the unemployment gap

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 The Phillips Curve
• Suppose the economy is in • To see why this is so, rewrite
equilibrium with prices stable equation (1) in terms of current
and unemployment at the and past wage levels:
natural rate
– If money supply increases by
10%, wages and prices both
must increase by 10% for the For wages to rise above previous
economy to return to levels, u must fall below the natural
equilibrium rate
– PC shows:
 If wages increase by 10%,
unemployment will have to
fall
 If wages increase, price will
increase and the economy will
return to the full employment
level of output and
unemployment

6-5
 The Policy Tradeoff
• PC quickly became a
cornerstone of
macroeconomic policy
analysis since it suggests that
policy makers could choose
different combinations of u
and  rates
– Can choose low u if willing
to accept high  (late 1960’s)
– Can maintain low  by
having high u (early 1960’s)
• In reality the tradeoff between
u and  is a short run
phenomenon
– Tradeoff disappears as AS
becomes vertical

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 The Inflation Expectations-
Augmented Phillips Curve
• Figure 6-4 shows the behavior
of  and u in the US since
1960  does not fit the simple
PC story
– Individuals are concerned
with standard of living, and
compare wage growth to
inflation
– If wages do not “keep up” with
inflation, standard of living falls
– Individuals form
expectations as to what 
will be over a particular
period of time, and use in
wage negotiations (e)
• Rewrite (2) to reflect this as:
( g w   e )   (    * ) (3)

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 The Inflation Expectations-
Augmented Phillips Curve
• If maintaining the assumption of a constant real wage, W/P,
actual  will equal wage inflation
• The equation for the modern version of the PC, the expectations
augmented PC, is:

( g w   e )   (    * ) 
(    e )   (    * )  (4)
  e   (  * )

NOTE:
1. e is passed one for one into actual 
2. u = u* when e = 

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 The Inflation Expectations-
Augmented Phillips Curve
• The modern PC
intersects the natural
rate of u at the level of
expected inflation
• Figure 6-5 illustrates the
inflation expectations-
augmented Phillips
curve for the 1980s and
early 2000
• The height of the SRPC
depends upon e

6-9
 The Inflation Expectations-
Augmented Phillips Curve
• Changes in expectations
shifts the curve up and
down
– The role of e adds
another automatic
adjustment mechanism to
the AS side of the
economy
• When high AD moves the
economy up and to the left
along the SRPC,  results
– if persists, people adjust
their expectations
upwards, and move to
higher SRPC

6-10