ECON 101
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Session 24: Post Mid Term
• How AS shifts effect the Phillips curve?
• What Phillips curve tells us about the cost of
disinflation?
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Inflation expectations and Phillips curve
• The short run Phillips curve is negatively sloped because inflation
expectations are fixed
• If policymaker tries to exploit the trade off between inflation and
unemployment, agents will adjust their expectations accordingly
• This shift in inflation expectations in response to change in policy
makers preferences will shift the Phillips curve
• In the long run the Phillips curve will be vertical
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Vertical Phillips curve The negative slop of the Phillips curve is due to fixed inflation
expectations. When expectations adjust, AS curve shifts, becomes
green AS curve. This shift in expectations cause Phillips curve to
shift upward to blue Phillips curve.
Long run Phillips
curve
Prive level Inflation
Phillips
curve
Real GDP Unemployment%
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• In the long run, unemployment will not change when aggregate
demand changes, but inflation will.
• The long-run aggregate-supply curve occurs at the economy’s
natural rate of output. This means that the long-run Phillips
curve occurs at the natural rate of unemployment.
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Meaning of “natural” in the natural rate of
unemployment
• Natural rate of unemployment is the rate towards which the
economy gravitates in the long run.
• The natural rate of unemployment may not be the socially
desirable rate of unemployment.
• The natural rate of unemployment may change over time.
• Another name of natural rate is non-accelerating inflation rate of
unemployment (NAIRU)
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Actual and natural rate of unemployment
• The Phillips curve shows the link between actual unemployment,
natural unemployment, the actual inflation rate, and the
expected inflation rate:
• Because expected inflation is already given in the short run,
higher actual inflation leads to lower unemployment.
• How much unemployment changes in response to a change in
inflation is determined by the variable , which is related to the
slope of the short run aggregate-supply curve 8
• Taking advantage of the short-run trade-off between unemployment
and inflation is possible through dodging agents’ expectations
• Suppose the economy is at point 1 and policymakers wish to lower
the unemployment rate.
• Expansionary monetary policy or fiscal policy is used to shift
aggregate demand to the right. The economy moves to point 2, with a
lower unemployment rate and a higher rate of inflation.
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Exploiting Phillips curve tradeoff
Inflation Long run PC
PC @ Exp(0)
Unemployment
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• Over time, people get used to this new level of inflation and raise
their expectations of inflation. This leads to an upward shift of the
short-run Phillips curve. The economy ends up at point C, with a
higher inflation rate than at point A, but the same level of
unemployment.
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Exploiting Phillips curve tradeoff
PC @ Exp(1)
PC @ Exp(0)
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Exploiting Phillips curve tradeoff
PC @ Exp(2)
PC @ Exp(1)
PC @ Exp(0)
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Supply shocks and Phillips curve
• The recent disruption in world energy markets due to Russia-
Ukraine war is an example of aggregate supply shock
• This is a negative supply shock i.e., it shifts the AS curve
leftward
• A shift in AS curve also shifts the Phillips curve
• Supply shock: an event that directly alters firms’ costs and
prices, shifting the economy’s aggregate-supply curve and
thus the Phillips curve.
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Negative Supply shock
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Negative supply shock and Phillips curve
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• Given this turn of events, policymakers are left with a less favorable
short-run trade-off between unemployment and inflation.
• If they increase aggregate demand to fight unemployment, they will
raise inflation further.
• If they lower aggregate demand to fight inflation, they will raise
unemployment further
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Cost of reducing inflation
• To reduce the inflation rate, the central bank must follow contractionary
monetary policy
• When central bank slows the rate of growth of the money supply, aggregate
demand falls.
• This reduces the level of output in the economy, increasing unemployment.
• The economy moves from point A along the short-run Phillips curve to point
B, which has a lower inflation rate but a higher unemployment rate.
• Over time, people begin to adjust their inflation expectations downward and
the short-run Phillips curve shifts. The economy moves from point B to point
C, where inflation is lower and the unemployment rate is back to its natural
rate.
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Cost of reducing inflation
• The economy moves from
point A along the short-run
Phillips curve to point B,
which has a lower inflation
rate but a higher
unemployment rate.
• Over time, people begin to
adjust their inflation
expectations downward and
the short-run Phillips curve
shifts. The economy moves
from point B to point C,
where inflation is lower and
the unemployment rate is
back to its natural rate.
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Clarifying two terms: disinflation and deflation
• Disinflation means reduction in the rate of inflation
• Disinflation: Inflation reduces from 12 percent to 8 percent
• Deflation is negative inflation i.e., inflation moves from 4 percent to
minus 2 percent
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Sacrifice ratio
• The number of percentage points of annual output lost in the
process of reducing inflation by one percentage point.
• A typical estimate of the sacrifice ratio is five. This implies that
for each percentage point inflation is decreased, output falls
by 5%.
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Rational expectations
• The theory according to which people optimally use all the
information they have, including information about government
policies, when forecasting the future
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Rational expectations and speed of adjustment
• The cost of reducing inflation is due to slow speed of expectations
adjustment
• Proponents of rational expectations believe that when
government policies change, people alter their expectations about
inflation.
• Therefore, if the government makes a credible commitment to a
policy of low inflation, people would be rational enough to lower
their expectations of inflation immediately.
• This implies that the short-run Phillips curve would shift quickly
without any extended period of high unemployment.
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See you next time
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