Phillips Curve and Stabilization Policy

Intermediate

The Phillips Curve is one of the most important models in macroeconomics, illustrating the relationship between inflation and unemployment. In the short run, the short-run Phillips Curve (SRPC) shows an inverse tradeoff: when unemployment falls below the natural rate, inflation tends to rise, and vice versa. W. Phillips in 1958 using UK wage data. However, the stagflation of the 1970s, when both inflation and unemployment rose simultaneously, revealed the limitations of this short-run relationship and led economists like Milton Friedman and Edmund Phelps to develop the expectations-augmented Phillips Curve.

Their insight was that the long-run Phillips Curve (LRPC) is vertical at the natural rate of unemployment, meaning there is no permanent tradeoff between inflation and unemployment. In the long run, the economy self-corrects to the natural rate regardless of the inflation rate, as workers and firms adjust their expectations. Stabilization policy encompasses the fiscal and monetary tools governments and central banks use to smooth the business cycle, but these tools carry long-run consequences. Expansionary fiscal policy can crowd out private investment by raising interest rates in the loanable funds market.

Persistent deficits raise the national debt, with implications for future growth and interest payments. Supply-side policies that increase productivity, human capital, and technology can shift the LRAS curve rightward, raising potential output. Understanding the interaction between short-run stabilization and long-run growth is essential for evaluating policy tradeoffs on the AP Macroeconomics exam.

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A curve showing the inverse relationship between the inflation rate and the unemployment rate in the short run, holding inflation expectations constant. Movement along the SRPC occurs when aggregate demand changes.

Example

When the Federal Reserve cuts interest rates and stimulates aggregate demand, unemployment falls from 6% to 4% but inflation rises from 2% to 4%, tracing a movement up and to the left along the SRPC.

A vertical line at the natural rate of unemployment, indicating that in the long run there is no tradeoff between inflation and unemployment. The economy returns to the natural rate regardless of the inflation rate once expectations fully adjust.

Example

If the government uses expansionary policy to push unemployment below 5% (the natural rate), inflation rises. Workers eventually demand higher wages to match inflation, pushing unemployment back to 5% but at a higher inflation rate, a point on the same vertical LRPC.

The unemployment rate that prevails when the economy is at full employment, consisting only of frictional and structural unemployment with zero cyclical unemployment. It is the rate at which the LRPC is vertical.

Example

If frictional unemployment is 2% and structural unemployment is 3%, the natural rate is 5%. Even in a healthy economy, 5% of the labor force is between jobs or lacks matching skills.

The rate of inflation that workers, firms, and consumers anticipate in the future. Changes in inflation expectations shift the entire short-run Phillips Curve: higher expected inflation shifts the SRPC upward (rightward), lower expected inflation shifts it downward (leftward).

Example

If workers expect 3% inflation instead of 1%, they negotiate higher wages immediately. This shifts the SRPC up so that at the natural rate of unemployment, the actual inflation rate is 3% instead of 1%.

The reduction in private investment that occurs when increased government borrowing drives up interest rates in the loanable funds market. Crowding out reduces the long-run effectiveness of expansionary fiscal policy because the increase in government spending is partially offset by decreased private investment.

Example

The government borrows billion to fund a stimulus. This increases demand for loanable funds, pushing interest rates from 4% to 6%. At the higher rate, some businesses cancel expansion plans, so total spending increases by less than billion.

The factors that increase an economy's potential output over time, shifting the LRAS curve rightward. The four main determinants are increases in physical capital (tools, machines, infrastructure), human capital (education, training, health), technology and innovation, and natural resources.

Example

A country that invests heavily in education (human capital) and research (technology) sees its LRAS shift right over time, raising potential GDP from 20 trillion to 22 trillion without causing inflation.

The percentage of a year's real GDP that must be forgone to reduce inflation by one percentage point. It measures the short-run cost of disinflation and explains why central banks often reduce inflation gradually rather than abruptly.

Example

If the sacrifice ratio is 5, reducing inflation from 6% to 2% (a 4-point reduction) would cost 20% of one year GDP in lost output, spread over several years of above-natural-rate unemployment.

Government policies designed to increase aggregate supply and potential output by improving incentives and productivity. These include tax reforms, deregulation, education investment, and infrastructure spending. Unlike demand-side policies, supply-side policies can increase real GDP without raising the price level.

Example

A government reduces corporate tax rates and invests in STEM education, increasing business investment and workforce productivity. The LRAS shifts right, allowing higher output at a stable or lower price level.

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Grade level

Grades 9-12College+

Learning objectives

•Explain the short-run Phillips Curve and the tradeoff between inflation and unemployment
•Explain the long-run Phillips Curve and why it is vertical at the natural rate of unemployment
•Analyze how changes in inflation expectations shift the short-run Phillips Curve
•Evaluate the long-run effects of fiscal and monetary policy on output and the price level
•Explain crowding out and its impact on private investment and economic growth
•Analyze the determinants of economic growth (physical capital, human capital, technology, natural resources)
•Evaluate the long-run sustainability of deficits and the national debt

Phillips Curve and Stabilization Policy

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Key Concepts

Short-Run Phillips Curve (SRPC)

Long-Run Phillips Curve (LRPC)

Natural Rate of Unemployment

Inflation Expectations

Crowding Out

Economic Growth Determinants

Sacrifice Ratio

Supply-Side Policy

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