Phillips Curve Flashcards
Explain What a Phillips Curve is? Explain the SRPC aswell? What Trade off does it have?
The Phillips curve is a graph that shows how inflation rates and unemployment rates are related to each other, both in the short-run and long-run. It is actually just a reflection of the AD/AS graph. In the short-run, there is a trade-off between inflation and unemployment
This graph deals with the twin evils (inflation and unemployment) continue to trade off. Unfortunately, we don’t live in a perfect world, so we can never have inflation low and unemployment low at the same. When both are high, it’s called stagflation, and it happens when the economy is (literally) on the verge of collapsing
In the short run, inflation and unemployment have an inverse relationship. However, in the long run, unemployment will stay at a natural rate (reflecting the vertical nature of the long run Philips curve). The economy is always operating somewhere along the short-run Phillips curve, while in the long run, unemployment stays at a natural rate. Therefore, the long-run equilibrium is the intersection of SRPC and LRPC.
The economy is always operating somewhere along SRPC
Why is there an inverse relationship between unemployment and inflation? How does it relate to prices?
Inflation is low when unemployment is high because fewer people are working, and there is less demand for goods and services. As a result, prices don’t rise as fast. When unemployment gets lower, inflation gets higher because so many more people have jobs and the money to spend on things. This means that there is a higher demand for goods and services, which increases prices
Explain The Shift of AD, where AD decreases. What effect does this have on the SRAS? Draw a Graph
The AS/AD graph and the Phillips curve have a lot in common. In the AS/AD graph, a decrease in AD causes a change in equilibrium from point A to point B. The same change in AD that causes the price level (PL) to fall and the real GDP to fall causes inflation to fall but unemployment to rise. This is mirrored on the short-run Phillips curve with a movement from point A to point B. See graph below
Explain The Shift of AD, where AD increases. What effect does this have on the SRAS? Draw a Graph
In the AS/AD graph, an increase in AD causes a change in equilibrium from point A to point B. The same change in AD that causes the price level (PL) to increase and the real GDP to increases causes inflation to rise but unemployment to fall. This is mirrored on the short-run Phillips curve with a movement from point A to point B.
Shifting SRAS: Explain what happens in the Long Run when SRAS shifts left or right. Draw a Graph.
Shifiting SRAS
Whenever something makes the SRAS curve shift right or left, the short-run Phillips Curve (SRPC) shifts in the opposite direction. If the SRAS curve shifts right, the SRPC will shift left, causing price level (inflation) and unemployment to fall. However, if the SRAS curve shifts left, the SRPC will shift right, indicating stagflation because unemployment rate and inflation are both increasing.
In the case of the graph below, an increase in the SRAS curve, a shift to the right of this curve to SRAS1, will result in a leftward shift of the SRPC curve.
A decrease in the SRAS curve, a shift to the left of this curve, will result in a rightward shift of the SRPC curve.
Explain the LRPC. Draw a Graph.
The long-run Phillips curve (LRPC) shows that, in the long-run, there is no trade-off between inflation and unemployment. The LRPC exists at an economy’s natural rate of unemployment, which just so happens to correspond to full employment and the LRAS. The graph below shows an LRPC at the economy’s natural rate of unemployment of 5%. When an economy’s natural rate of unemployment changes, so does LRPC. The LRPC tells us that policies to change the level of employment in the economy will ultimately result in only changes in the inflation rate.
What is Natural Rate of Unemployment
Natural Rate of Unemployment - not influenced by monetary policy. It is affected by things like minimum wage laws, employment insurance, collective bargaining by unions. It is also called the NAIRU (Non-Accelerating Inflation Rate of Unemployment).
Draw a Graph showing the short run and long run Phillips curve affects of a Expansionary Monetary Policy. Explain.
If there’s expansionary monetary policy the Aggregate Demand will shift right causing actual inflation to increase and unemployment to decrease which would be a movement along the Phillips curve from point A to point B
This would lead to higher expected inflation so the short run Phillips curve will shift up (LR)
The long run Phillips curve remains the same vertical line.
Draw the effects of a Supply Shock on the Phillips curve. Explain
SRAS decreases shifts left, SRPC shifts right.
Explain how Money growth (supply) connects with inflation
Inflation is most certainly the result of increasing the money supply. Think about monetary policies. When the Fed increases the money supply through its open market operations, changing the reserve ratio, and changing the interest rate. This does close the recessionary gap, but it can lead to inflation. This is the same for deflation. If the money supply decreases, the inflationary gap will be closed, but the price level will decrease.
Explain Demand Pull Inflation. Draw a Graph.
Demand-pull inflation is caused by an increase in consumer demand. It happens when AD shifts to the right with consumers spending more. When this happens, the price level increases, but real GDP also increases. This demand-pull is also thought to be caused by too much government deficit spending, because government spending usually drives up AD
Seen in the graph above, AD1 shifts to the right to AD2, increasing both price and real GDP. This is also known as the inflationary gap, and it is corrected through long-run adjustment and contractionary fiscal or monetary policies.
Explain Cost Push Inflation. Draw A Graph.
Cost-push inflation happens when production is decreased (or input costs increased, thus decreasing amount of production). This can be caused by labor or natural resource shortages as well or natural disasters. Anything that disturbs production and decreases supply is though to be cost-push inflation
With this type of inflation, supply shortages happen, leading to AS1 (short-run in this case) shifting to the left to AS2. This drives price level to increase but real GDP to decrease. This is a bad example of inflation because it’s a little harder to fix.
Explain the Wage Price Spiral Effect. Draw a graph.
This is the worst case scenario. It’s just a self-perpetuating spiral where demand rises and supply goes down. Imagine if everyone wants to buy more of everything but the supply of everything keeps going down due to a bad hurricane or earthquake? Basically, in this case, demand-pull and cost-push are working together, which is the worst case with inflation.
Since everything is now at higher prices, it’s reasonable that everyone would want higher wages to be able to afford those high costs. This would cause prices to go up even more because it’s more expensive to produce now with higher wages. This will lead to more inflation, then higher prices of everything, then higher demand for wages, then higher production costs, then inflation… It just keeps going.
As seen in the graph, we have a double shifter. AD is shifting to the right, while SRAS is shifting to the left. As a result, real GDP is unchanged, but we still have an increase in price level.
What is the Virtuous Cycle?
Low inflation, low inflation expectations
What is the Vicious Cycle?
High inflation, high inflation expectations
