Chapter 11

Aggregate
Supply and the
Phillips Curve
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• To understand how the economic

profession’s views on the Phillips curve
evolved over time and how it has affected
thinking about macroeconomic policy
• To understand how to use the Phillips curve
to derive the aggregate supply curve

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 The Phillips Curve

• The Phillips curve shows the negative

relationship between unemployment and
inflation
• Named after the New Zealand economist
A.W. Phillips for his empirical paper (1958)
on the relationship between unemployment
and wage growth in the United Kingdom
• The Phillips curve seemed to fit the data in
the 1960s very well

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 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
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 FIGURE 11.1 Inflation and Unemployment
in the United States, 1950-1969 and 1970-
2013 (a)

Source: Economic Report of the President. www.gpoaccess.gov/eop/

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 FIGURE 11.1 Inflation and Unemployment
in the United States, 1950-1969 and 1970-
2013 (b)

Source: Economic Report of the President. www.gpoaccess.gov/eop/

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 The Friedman-Phelps Phillips Curve
Analysis

• Milton Friedman and Edmund Phelps pointed

out that 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

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 The Friedman-Phelps Phillips Curve
Analysis (cont’d)

• 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 (cont’d)

• 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 expectations-
augmented Phillips curve is the long-run Phillips
curve (LRPC)

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 The Friedman-Phelps Phillips Curve
Analysis (cont’d)

• 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
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 FIGURE 11.2 The Short- and Long-
Run Phillips Curve

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 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)
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 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

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 The Modern Phillips Curve with Adaptive
(Backward-Looking) Expectations (cont’d)

π
• Substituting -1 in for π e
in the expectations-
augmented Phillips curve so that the short-
run Phillips curve becomes:

  1  (U  Un )  
or     1  (U  Un )  

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 The Modern Phillips Curve with Adaptive
(Backward-Looking) Expectations (cont’d)

• 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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 FIGURE 11.3 Long- and Short-Run
Aggregate Supply Curves

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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 )
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 FIGURE 11.4 Okun’s Law, 1960-2013

Source: Unemployment, quarterly, 1960–2013 and real GDP growth, quarterly, 1960–2013.
Bureau of Labor Statistics and Bureau of Economic Analysis.

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 The Short-Run Aggregate Supply
Curve (cont’d)

• Substituting in Okun’s law for (U  U n ) in the

short-run Phillips curve so that the short-run
aggregate supply curve is (assuming =0.5 ):
  e  (Y  Y P )  
Inflation  Expected    Output  Price
Inflation Gap Shock

e
• With adaptive expectations ( =1 ) :
  1  (Y  Y P )  

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 The Short-Run Aggregate Supply
Curve (cont’d)

• Numerical example:
– Assume 1  2%, =0, =1.5, and Y P= $10 trillion
– The short-run aggregate supply curve becomes:

  2  1.5  (Y  10)

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 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 short-
run aggregate supply curve becomes
vertical and so it is identical to the LRAS
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 Box: The Relationship of the Phillips Curve
and the Short-Run Aggregate Supply Curve

• The short-run aggregate supply curve is in

reality just a Phillips curve, with the
unemployment gap replaced by an output gap
• Because Okun’s law implies that output gaps
and unemployment gaps are inversely related,
the negative relationship between inflation and
the unemployment gap implies a positive
relationship between inflation and the output gap

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 Shifts in Aggregate Supply
Curves

• Shifts in the long-run aggregate supply

curve can come from factors that change
potential output (Ch. 3):
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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 FIGURE 11.5 Shift in the Long-Run
Aggregate Supply Curve

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 Shifts in the Short-Run Aggregate
Supply Curve

• Factors that can shift the short-run AS curve:

1. Expected inflation
– Higher (lower) expected inflation rises (lowers) the short-run
aggregate supply curve
2. Price shock
3. Persistent output gap
– E.g., a persistent positive output gap, Y($11 trillion)>YP($10
trillion), occurs so that inflation and thus expected inflation
rises from 2% to 3.5%. The short-run aggregate supply
curve with e=3.5% :
  3.5  1.5  (Y  10)

which will shifts upwards next period as e rises to

5%(=3.5%+1.5[11-10]), so that:
  5.0  1.5  (Y  10)
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 FIGURE 11.6 Shift in the Short-Run
Aggregate Supply Curve from Changes in
Expected Inflation and Price Shocks

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 FIGURE 11.7 Shift in the Short-Run
Aggregate Supply Curve from a Persistent
Positive Output Gap

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 Chapter 12

The Aggregate
Demand and
Supply Model
 Equilibrium in Aggregate
Demand and Supply Analysis
• General equilibrium in the economy
occurs when all markets are simultaneously
in equilibrium at the point where the
quantity of aggregate output demanded
equals the quantity of aggregate output
supplied
• Graphically, general equilibrium is the point
where the AD curve intersects with the AS
curve
• Short-run and long-run equilibriums exist
because there are two AS curves—one for
the short run and one for the long run.
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 Short-Run Equilibrium

• Graphically, a short-run equilibrium occurs

when the aggregate demand curve AD and
the short-run aggregate supply curve AS
intersect

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 FIGURE 12.1 Short-Run Equilibrium

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 Box: Algebraic Determination of the
Equilibrium Output and Inflation Rate

• The AD curve (Ch.10):

Y  11  0.5π

• The short-run AS curve (Ch.11) with π-1  2%

π  2  1.5(Y 10)

• Substituting in for  from the AS curve into the AD curve

so that equilibrium Y is:

Y  11  0.5  [2  1.5(Y 10)]

• Collecting terms in Y so that Y*=10, which is substituted
into the short-run AS curve to yield the equilibrium
inflation rate:
π*  2  1.5(10 10)  2
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 Long-Run Equilibrium

• In aggregate supply and demand analysis,

even when the economy is at the
intersection of the aggregate demand curve
and the short-run aggregate supply curve,
the equilibrium will move over time if output
differs from its potential level (Y*  YP)
• If the current level of inflation changes from
its initial level, the short-run aggregate
supply curve will shift as wages and prices
adjust to a new expected rate of inflation

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 Short-Run Equilibrium over Time

• What happens to the short-run equilibrium

over time if the short-run equilibrium output
is initially above potential output?
– Tightness in labor markets drives up wages,
which result in higher inflation and inflation
expectations, thus the AS curve shifts up and to
the left over time until output returns to its
potential level

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 Short-Run Equilibrium over Time

• What happens to the short-run equilibrium

over time if the short-run equilibrium output
is initially below potential output?
– Excess slack in labor markets drives down
wages, which result in lower inflation and
inflation expectations, thus the AS curve shifts
down and to the right over time returns to its
potential level

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 FIGURE 12.2 Adjustment to Long-Run
Equilibrium in Aggregate Supply and
Demand Analysis (a)

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 FIGURE 12.2 Adjustment to Long-Run
Equilibrium in Aggregate Supply and
Demand Analysis (b)

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 Short-Run Equilibrium over Time
(cont’d)

• According to the aggregate demand and

supply model, regardless of where output is
initially, it eventually returns to potential
output
• This is called the self-correcting
mechanism because the short-run
aggregate supply curve shifts up or down to
restore the economy to full employment
(aggregate output at potential) over time

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