5. Aggregate Supply and Phillips Curve

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The Phillips Curve • The Phillips curve shows the negative relationship between unemployment and inflation • A.W. Phillips for his empirical paper (1958) on the relationship between unemployment and wage growth in the United Kingdom - when the labor markets are tight, the unemployment is low, firms are difficult to hire good workers and keep their present employees. - So, he firms should raise wages to attract needed workers and raise their prices at a rapid rate. • The Phillips curve seemed to fit the data in the 1960s very well 2

Policy and Practice: The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s • In 1960, Paul Samuelson and Robert Solow published a paper outlining how policymakers could exploit the Phillips curve tradeoff between inflation and unemployment - The Kennedy and Johnson administrations followed their advice and pursued expansionary macroeconomic policies that subsequently raised inflation a little bit and brought unemployment down • From the late 1960s through the 1970s, however, inflation accelerated while the unemployment rate remained high – “Stagflation” 3

The Friedman-Phelps Phillips Curve Analysis • Milton Friedman and Edmund Phelps pointed out severe theoretical flaws in the Phillips curve analysis - firms and workers care about real wages, not nominal wages - when the price level is expected to rise, the nominal wage will adjust upward so that real wages does not decrease. - when all wages and prices were flexible in the long run, the economy would reach the natural rate of unemployment, or the full-employment level of unemployment 4

The Friedman-Phelps Phillips Curve Analysis • Their reasoning comes from the expectations-augmented Phillips curve:   e  (U  Un ) where   inflation e  expected inflation   sensitivity of  to unemployment gap (U  Un ) U  unemployment Un  natural rate of unemployment

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The Friedman-Phelps Phillips Curve Analysis • Suppose the unemployment rate is below the natural rate, then: – The economy will first move leftward along the Phillips curve with rising inflation – In the long run, expected inflation must gravitate to actual inflation, so that the Phillips curve shifts upward until expected inflation equals the new inflation rate – The line connecting the shifting expectationsaugmented Phillips curve is the long-run Phillips curve (LRPC) 6

The Friedman-Phelps Phillips Curve Analysis • Conclusions of the Friedman-Phelps Phillips curve analysis: 1. There is no long-run tradeoff between unemployment and inflation 2. There is a short-run tradeoff between unemployment and inflation 3. There are two types of Phillips curves, long run and short run

• The Friedman-Phelps Phillips curve analysis explains the disappearance of the negative relationship between unemployment and inflation after the 1960s 7

The Modern Phillips Curve • Given the sharp rise in oil prices in 1973 and 1979, economists further modified the short-run Phillips curve with price shocks ρ (_)—shifts in inflation that are independent of the tightness in the labor markets or of expected inflation:   e  (U  Un )  

• Examples of price shocks are a rise in import prices and cost-push shocks, in which workers push for wages higher than productivity gains) 8

The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations • How do firms and households form inflation expectations? • One form of expectations is adaptive expectations or backward-looking expectations, such as forming inflation expectations by looking eat the inflation rate in the previous period (π ) : e

  1 9

The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations e π in for π • Substituting -1 in the expectationsaugmented Phillips curve so that the shortrun Phillips curve becomes:

  1  (U  Un )   or

    1  (U  Un )  

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The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations • The equation is also known as an accelerationist Phillips curve because a negative unemployment gap causes the inflation to accelerate • Un is now also called the Non-Accelerating Inflation Rate of Unemployment (NAIRU) because it is the rate at which inflation stops accelerating

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The Aggregate Supply Curve • An aggregate supply curve represents the relationship between the total quantity of output that firms are willing to produce and the inflation rate • Long-run aggregate supply curve (LRAS) – Vertical at potential output or the natural rate of output—the level of production that an economy can sustain in the long run, YP

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The Short-Run Aggregate Supply Curve • A short-run aggregate supply curve can be derived from the modern Phillips curve by replacing the unemployment gap (U  U n ) with the output gap between actual output and potential output (Y  Y P ) • The negative relationship between the unemployment gap and the output gap is captured by Okun’s law, named after Arthur Okun:

U  U n  0.5  (Y  Y P )  for 1% increase in output above the potential level, the unemployment rate decreases by 0.5% below the natural rate. 13

The Short-Run Aggregate Supply Curve (cont’d) • The short-run Phillips curve implies wages are prices are sticky • The short-run aggregate supply curve assumes sticky wages and prices because it is derived from the short-run Phillips curve • The value of  indicates the steepness of the short-run aggregate supply curve • When wages and prices are completely flexible,  becomes so large that the shortrun aggregate supply curve becomes vertical and so it is identical to the LRAS 14

The Short-Run Aggregate Supply Curve •The AS relation has two important properties:

– An increase in output leads to an increase in the price level. This is the result of four steps: 1. An increase in output leads to an increase in employment.Y   N  2. The increase in employment leads to a decrease in unemployment and therefore to a decrease in the unemployment rate. N   u  3. The lower unemployment rate leads to an increase in the nominal wage. u  W  4. The increase in the nominal wage leads to an increase in the prices set by firms and therefore to an increase in the price level. W  P  15

The Short-Run Aggregate Supply Curve The second property of the AS relation is that:

• –

An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages: P ethe W  level to be higher, they set 1. If wage setters expect price a higher nominal wage.

2. The increase in the nominal wage leads to an increase in   P to an increase in the prices set by firms costs, whichWleads and a higher price level.

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The Short-Run Aggregate Supply Curve

The Aggregate Supply Curve Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.

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The Short-Run Aggregate Supply Curve

The AS curve has three properties that will prove useful in what follows:

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The aggregate supply curve is upward sloping. Put another way, an increase in output, Y, leads to an increase in the price level, P.

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The aggregate supply curve goes through point A, where Y = Yn and P = Pe.

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An increase in the expected price level, Pe, shifts the aggregate supply curve up. Conversely, a decrease in the expected price level shifts the aggregate supply curve down.

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The Short-Run Aggregate Supply Curve

The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve An increase in the expected price level shifts the aggregate supply curve up.

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The Short-Run Aggregate Supply Curve •

Let’s summarize:

 Starting from wage determination and price determination in the labor market, we have derived the

aggregate supply relation.

 This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the

aggregate supply curve.

 Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down. 20

Shifts in Aggregate Supply Curves • Shifts in the long-run aggregate supply curve can come from factors that change potential output : 1. The total amount of capital 2. The amount of labor supplied 3. The available technology that puts labor and capital together in producing goods and services

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