MacroeconomicsI_working_version (1)

The Phillips Curve 99
∆P/P
∆W/W
Price inflation (percent per year)
8
7
6
5
4
3
2
1
Phillips curve
10
9
8
7
6
5
4
3
Annual wage rise (percent per year)
0
2
1 2 3 4 5 6 7 8 9 10
Unemployment rate
Figure 10.1 The Phillips curve illustrates the trade-off between inflation and unemployment 1 . The
inverse relationship between inflation and unemployment is depicted by the Phillips curve. The scale on the
right-hand vertical axis differs from the left-hand inflation scale by the assumed 2 percent rate of growth of
average labour productivity.
10.1. Interpretation of the Phillips Curve
Let’s put the Phillips curve into a context of AS-AD model and explain the relationship
between inflation and unemployment through moving AS and AD curves. We will explain
this relationship comparing Figure 9.3 (in chapter 9) describing process of inertial inflation
and Figure 10.1.
Consider potential output corresponding to 6 percent rate of unemployment. At this point,
output equals its potential; unemployment remains at 6 percent, and price-level keeps in
rise at 4 percent per year. Assume, that a shift in aggregate demand occurs in the third
period, so the equilibrium is at point E’’’ rather then E’’ in Figure 9.3. Accordingly
unemployment will rise above 6 percent as output falls below potential and inflation will
also decrease. Compare the process with the Figure 10.1 to be clear.
The Phillips curve depicted in Figure 10.1 is only a short run curve; however, it might shift
in the long run. Unforeseen inflation (inflation shock) will change expectations of people
and accordingly changes wages and costs. A new rate of inertial inflation will be set, as
changing aggregate supply will reflect all these changes. This process will result in shifting
Phillips curve.
1 See Samuelson-Nordhaus [11]