The Phillips Curve. OpenStax College

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1 OpenStax-CNX module: m The Phillips Curve OpenStax College This work is produced by OpenStax-CNX and licensed under the Creative Commons Attribution License 4.0 By the end of this section, you will be able to: Abstract Explain the Phillips curve, noting its impact on the theories of Keynesian economics Graph a Phillips curve Identify factors that cause the instability of the Phillips curve Analyze the Keynesian policy for reducing unemployment and ination The simplied AD/AS model that we have used so far is fully consistent with Keynes's original model. More recent research, though, has indicated that in the real world, an aggregate supply curve is more curved than the right angle used in this chapter. Rather, the real-world AS curve is very at at levels of output far below potential (the Keynesian zone), very steep at levels of output above potential (the neoclassical zone) and curved in between (the intermediate zone). This is illustrated in Figure 1 (Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve). The typical aggregate supply curve leads to the concept of the Phillips curve. Version 1.8: May 2, :46 pm

2 OpenStax-CNX module: m Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Figure 1: Near the equilibrium Ek, in the Keynesian zone at the far left of the SRAS curve, small shifts in AD, either to the right or the left, will aect the output level Yk, but will not much aect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone, at the far right of the SRAS curve, small shifts in AD, either to the right or the left, will have relatively little eect on the output level Yn, but instead will have a greater eect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP (as represented by the LRAS line) largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level. 1 The Discovery of the Phillips Curve In the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession inationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for ination. Phillips analyzed 60 years of British data and did nd that tradeo between unemployment and ination, which became known as a Phillips curve. Figure 2 (A Keynesian Phillips Curve Tradeo between Unemployment and Ination) shows a theoretical Phillips curve, and the following Work It Out feature shows how the pattern appears for the United States.

3 OpenStax-CNX module: m A Keynesian Phillips Curve Tradeo between Unemployment and Ination Figure 2: A Phillips curve illustrates a tradeo between the unemployment rate and the ination rate; if one is higher, the other must be lower. For example, point A illustrates an ination rate of 5% and an unemployment rate of 4%. If the government attempts to reduce ination to 2%, then it will experience a rise in unemployment to 7%, as shown at point B. : Step 1. Go to this website 1 to see the 2005 Economic Report of the President. Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled Changes in special consumer price indexes, Step 3. Download the table in Excel by selecting the XLS option and then selecting the location in which to save the le. Step 4. Open the downloaded Excel le. Step 5. View the third column (labeled Year to year). This is the ination rate, measured by the percentage change in the Consumer Price Index. Step 6. Return to the website and scroll to locate the Appendix Table B-42 Civilian unemployment rate, Step 7. Download the table in Excel. 1

4 OpenStax-CNX module: m Step 8. Open the downloaded Excel le and view the second column. This is the overall unemployment rate. Step 9. Using the data available from these two tables, plot the Phillips curve for , with unemployment rate on the x-axis and the ination rate on the y-axis. Your graph should look like Figure 3 (The Phillips Curve from ). The Phillips Curve from Figure 3: This chart shows the negative relationship between unemployment and ination. Step 10. Plot the Phillips curve for What does the graph look like? Do you still see the tradeo between ination and unemployment? Your graph should look like Figure 4 (U.S. Phillips Curve, ).

5 OpenStax-CNX module: m U.S. Phillips Curve, Figure 4: The tradeo between unemployment and ination appeared to break down during the 1970s as the Phillips Curve shifted out to the right. Over this longer period of time, the Phillips curve appears to have shifted out. There is no tradeo any more. 2 The Instability of the Phillips Curve During the 1960s, the Phillips curve was seen as a policy menu. A nation could choose low ination and high unemployment, or high ination and low unemployment, or anywhere in between. Fiscal and monetary policy could be used to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeo between ination and unemployment, the result was an increase in both ination and unemployment. What had happened? The Phillips curve shifted. The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in backto-back recessions from 1980 to Many nations around the world saw similar increases in unemployment and ination. This pattern became known as stagation. (Recall from The Aggregate Demand/Aggregate Supply Model 2 that stagation is an unhealthy combination of high unemployment and high ination.) Perhaps most important, stagation was a phenomenon that could not be explained by traditional Keynesian economics. Economists have concluded that two factors cause the Phillips curve to shift. The rst is supply shocks, like the Oil Crisis of the mid-1970s, which rst brought stagation into our vocabulary. The second is changes in people's expectations about ination. In other words, there may be a tradeo between ination and unemployment when people expect no ination, but when they realize ination is occurring, the tradeo disappears. Both factors (supply shocks and changes in inationary expectations) cause the aggregate supply curve, and thus the Phillips curve, to shift. In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and ination are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or rst decade of the 2000s). 3 Keynesian Policy for Fighting Unemployment and Ination Keynesian macroeconomics argues that the solution to a recession is expansionary scal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 5 (Fighting Recession and Ination with Keynesian Policy), so that the economy was in recession, the appropriate policy would be for government to shift aggregate demand to the right from ADr to ADf, where the economy would be at potential GDP and full employment. Keynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern equivalent of the Egyptian pyramids. He proposed that the government could bury money underground, and let mining companies get started to dig the money up again. These suggestions were 2 "Introduction to the Aggregate Demand/Aggregate Supply Model" <

6 OpenStax-CNX module: m slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP. Fighting Recession and Ination with Keynesian Policy Figure 5: If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inationary rises in the price level are a concern. The Keynesian response would be contractionary scal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 5 (Fighting Recession and Ination with Keynesian Policy), so that the economy was experiencing inationary rises in the price level,

7 OpenStax-CNX module: m the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment. In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings ination. Thus, you can think of Keynesian economics as pursuing a Goldilocks level of aggregate demand: not too much, not too little, but looking for what is just right. 4 Key Concepts and Summary A Phillips curve shows the tradeo between unemployment and ination in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower ination, and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years. Keynesian macroeconomics argues that the solution to a recession is expansionary scal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inationary rises in the price level are a concern. The Keynesian response would be contractionary scal policy, using tax increases or government spending cuts to shift AD to the left. 5 Self-Check Question Exercise 1 (Solution on p. 8.) How would a decrease in energy prices aect the Phillips curve? 6 Review Questions Exercise 2 What tradeo is shown by a Phillips curve? Exercise 3 Would you expect to see long-run data trace out a stable downward-sloping Phillips curve? Exercise 4 What is the Keynesian prescription for recession? For ination? 7 Critical Thinking Questions Exercise 5 Do you think the Phillips curve is a useful tool for analyzing the economy today? Why or why not? 8 References Hoover, Kevin. Phillips Curve. The Concise Encyclopedia of Economics. U.S. Government Printing Oce. Economic Report of the President.

8 OpenStax-CNX module: m Solutions to Exercises in this Module Solution to Exercise (p. 7) A decrease in energy prices, a positive supply shock, would cause the AS curve to shift out to the right, yielding more real GDP at a lower price level. This would shift the Phillips curve down toward the origin, meaning the economy would experience lower unemployment and a lower rate of ination. Glossary Denition 1: contractionary scal policy tax increases or cuts in government spending designed to decrease aggregate demand and reduce inationary pressures Denition 2: expansionary scal policy tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession Denition 3: Phillips curve the tradeo between unemployment and ination