Macroeconomics Unit V & VI: Phillip's Curve

PHILLIP'S CURVE

Short Run Phillip's Curve

• time too short for wages to adjust to the price level
• workers may not be aware of changes in their real wages due to inflation and have adjusted their labor supply decisions and wage demands accordingly
• nominal wages: amount of money received per hour per day or per year
• sticky wages: nominal wage level that is set according to an initial price level and does not vary

LRAS Assumptions

• time not long enough for ages to adjust to price level
• price level and wage level is flexible
• changed in wage level & price level offset each other

Demand Pull

• AD increases
• AS decreases

Cost - Push

• AD increases
• AS decreases

Phillip's Curve

• represents relationship between unemployment and inflation
• occurs at natural rate of unemployment
• represented by a vertical line
• no trade off between unemployment and inflation in the long run
• economy produces at full employment level 
• only shift if LRAS curve shifts

LRAS Shift

• technological and economic growth

NRAU

• frictional
• seasonal
• structural

LPRC

• major assumptions: more workers benefits create increased natural rates and fewer create lower rates

SRAS

• trade off between inflation and unemployment that only occurs in short run
• when inflation increases, unemployment decreases
• inverse: high inflation = low unemployment

SPRC

• has relevance to Okun's Law
• since wages are sticky, inflation changes move points on the SRPC
• if inflation persists and expected rate of inflation rises, then entire SRPC moves upward which causes a situation called stagflation
• if inflation expectations decrease due to new technology or economic growth, then SRPC moves downward

AS Shocks

• cause both rate of inflation and unemployment to increase 

Supply Shock

• rapid increase in resource cost

Misery Index

• combination of inflation and unemployment in any given year
• single digit misery is good

Long Run Phillips Curve

• because LPRC exists at natural rate of unemployment, structural changes in the economy that affect unemployment will also cause LPRC to shift
• AD along the curve
• AS on curve

Supply Side Economics

• also called Reaganomics 
• belief that AS curve will determine levels of inflation, unemployment, and economic growth
• to increase the economy, would shift AS curve to the right
• economists focus on marginal tax rate
• decrease taxes or incentives for a business to invest in economy
• decrease taxes or incentives for workers to work hard, thereby becoming more productive 
• decrease taxes or incentives for people to increase savings and therefore create lower interest rates, which causes an increase in business investment
• support policies that promote GDP growth by arguing that high marginal tax rates along with current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneural ventures. 

Marginal Tax Rate

• amount paid on last dollar earned or each additional dollar earned

Laffer Curve

• trade off between tax rates and government revenue
• used to support supply side argument
• as tax rates increase from zero, tax revenue increases from zero to some max level and then declines

Criticisms

• research suggests that impact of tax rates on incentives to work, save, and invest are small
• tax cuts also increase demand which can fuel inflation, thus creating a situation where demand exceeds supply 
• where economy located on curve is difficult to determine