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Macro10_Inflation_Unemployment_PhillipsCurve

Macro10_Inflation_Unemployment_PhillipsCurve - Inflation...

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Inflation, Unemployment, and the Phillips Curve How the Phillips curve demonstrates the inflation- unemployment tradeoff that policy makers face.
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Building the Phillips Curve The Phillips curve states that inflation depends on expected inflation… ( ) e n u u v π π β = - - + the deviation of unemployment from the natural rate (cyclical unemployment)… and supply shocks.
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Building the Phillips Curve (1/ )( ) e P P Y Y v α = + - + (1/ )( ) e P P Y Y α = + - 1 1 ( ) (1/ )( ) e P P P P Y Y v α - - - = - + - + The Phillips curve is derived from aggregate supply. First we add an exogenous supply shock term to the right hand side. Then we subtract last year’s price level P -1 from both sides. (1/ )( ) e Y Y v π π α = + - + We can write inflation as π=(P–P -1 ) and expected inflation as π e =(P e –P -1 ). Recall Okun’s law. Which states that deviation of output from its natural rate is inversely related to deviation of unemployment from its natural rate. (1/ )( ) ( ) n Y Y u u α β - = - - ( ) e n u u v π π β = - - + By substituting we obtain the Phillips curve.
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Building the Phillips Curve So the Phillips curve and the short run aggregate supply curve essentially represent the same economic ideas.
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