Phillips and Laffer Curves

Unemployment and Inflation Relationship

The Philips Curve

The Phillips Curve• 1958, New Zealand born

economist, A.W. Phillips published the results of the relationship between the unemployment rate (u%) and the rate of inflation (π%) – Stable inverse relationship

between the u% and the π%.– As u%↓, π%↑ ; and as u%↑,

π%↓

• The implication: – policy makers could exploit

the trade-off and reduce u% at the cost of increased π%

The Phillips Curve(hypothetical example)

π%

u%

PC

4%

2%

7%5%

.. .

.

.

. .

Note: Inflation Expectations are held constant

Trouble for the Phillips Curve

• In the 1970’s the United States experienced stagflation (concurrent high u% & π%)

• Milton Friedman saw stagflation as disproof of the stable Phillips Curve.

• Instead of a trade-off between u% & π%, the natural u% was independent of the π%.

• This independent relationship is now referred to as the Long-Run Phillips Curve.

Trouble for the Phillips Curve

π%

u%

PC

4%

2%

7%5%

.. .

.

.

. ...

..

.

.

..

LRPC

The Long-Run Phillips Curve

π%

u%

LRPC

un

%Note: Natural rate of unemployment is held constant

The Long-Run Phillips Curve (LRPC)

• Structural changes in the economy that affect un will also cause the LRPC to shift.

• Increases in un will shift LRPC

• Decreases in un will shift LRPC

The Short-Run Phillips Curve (SRPC)

π%

u%

SRPC

4%

2%

7%5%

.. .

.

.

. ...

.. .

..

The key to understanding shifts in the Phillips curve is inflationary expectations!

The Short-Run Phillips Curve (SRPC)

π%

u%

SRPC

4%

2%

7%5%

.. .

.

.

. ...

.. .

..

SRPC1

The Philip’s “Curl”

SRPC (π^ %)

LRPC

π %

uN%

A

B Cπ1 %

u%

SRPC (π1^ %)

In the long-run, the inflation rate at B (π1 %)becomes the new expected inflation rate (π1

^%), and the economy returns to the natural rate of unemployment (point C).

Integrating the LRPC and SRPC

π%

u%

Government enacts an expansionary policy to reduce the unemployment rate below its natural rate at point A.

In the short-run (assuming the policy is successful) inflation occurs and unemployment decreases as the economy moves from A to B.

SRPC (π^ %)

LRPC

π %

uN%

A

BCπ1 %

u%

SRPC (π1^ %)

In the long-run, the inflation rate at B (π1 %)becomes the new expected inflation rate (π1

^%), and the economy, once again, returns to the natural rate of unemployment (point C).

Integrating the LRPC and SRPC

π%

u%

Now assume that the government enacts a contractionary policy to reduce inflation from it’s current rate at point A

In the short-run, assuming the policy is successful, disinflation occurs and unemployment increases as the economy moves from A to B.

Increase in AD = Up/left movement along SRPC—

“Mirror Graphs”

C↑, IG↑, G↑ and/or XN↑ AD ↑ GDPR↑ & PL↑ u%↓ & π%↑ up/left along

SRPC

GDPR

PL

AD

SRASLRAS

YF

P

Y

AD1

P1

SRPC

π

u

π%

u%un

π 1

. .. .

Decrease in AD = Down/right along SRPC

C↓, IG↓, G↓ and/or XN↓ AD ↓ GDPR↓ & PL↓u%↑ &π%↓ down/right

along SRPC

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

AD1

P1

u%

π%

SRPC

un

π

u

π1

. .. .

SRAS ↑ = SRPC ↓

Inflationary Expectations↓, Input Prices↓, Productivity↑, Business Taxes↓, and/or

Deregulation SRAS ↑ GDPR↑ & PL↓ u%↓ & π%↓ SRPC↓

(Disinflation)

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

SRAS1

P1

u%

π%SRPC

LRPC

un

π

u

SRPC1

π1

. .. .

SRAS ↓ = SRPC ↑

Inflationary Expectations↑, Input Prices↑, Productivity↓, Business Taxes↑, and/or Increased

Regulation SRAS ↓ GDPR↓ & PL↑ u%↑ & π%↑ SRPC ↑

(Stagflation)

GDPR

PL

AD

SRAS

LRAS

YF

P

Y1

SRAS1

P1

u%

π%

SRPC

LRPC

un

π

u1

SRPC1

π 1. .. .

Summary• There is a short-run trade off between u% & π%.

This is referred to as a short-run Phillips Curve (SRPC)

• In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)

• The LRPC exists at the natural rate of unemployment (un).– un ↑ LRPC ↑– un ↓ LRPC ↓

• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC– AD ↑ GDPR↑ & PL↑ u%↓ & π%↑ up/left along SRPC– AD ↓ GDPR↓ & PL↓ u%↑ & π%↓ down/right along SRPC

• Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC – SRAS ↑ GDPR↑ & PL↓ u%↓ & π%↓ SRPC ↓– SRAS ↓ GDPR↓ & PL ↑ u%↑ & π%↑ SRPC ↑