Aggregate Demand Aggregate Supply And The Phillips Curve

The model of aggregate demand and aggregate supply provides an easy explanation for the menu of possible outcomes described by the Phillips curve. The Phillips curve simply shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve. As we saw in Chapter 31, an increase in the aggregate demand for goods and services leads, in the short run, to a larger output of goods and services and a higher price level. Larger output means greater employment

Figure 33-1

The Phillips Curve. The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and unemployment is low.

Figure 33-1

The Phillips Curve. The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and unemployment is low.

and, thus, a lower rate of unemployment. In addition, whatever the previous year's price level happens to be, the higher the price level in the current year, the higher the rate of inflation. Thus, shifts in aggregate demand push inflation and unemployment in opposite directions in the short run—a relationship illustrated by the Phillips curve.

To see more fully how this works, let's consider an example. To keep the numbers simple, imagine that the price level (as measured, for instance, by the consumer price index) equals 100 in the year 2000. Figure 33-2 shows two possible outcomes that might occur in year 2001. Panel (a) shows the two outcomes using the model of aggregate demand and aggregate supply. Panel (b) illustrates the same two outcomes using the Phillips curve.

In panel (a) of the figure, we can see the implications for output and the price level in the year 2001. If the aggregate demand for goods and services is relatively low, the economy experiences outcome A. The economy produces output of 7,500, and the price level is 102. By contrast, if aggregate demand is relatively high, the economy experiences outcome B. Output is 8,000, and the price level is 106. Thus, higher aggregate demand moves the economy to an equilibrium with higher output and a higher price level.

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

(unemployment (unemployment of Output (output is (output is Rate (percent)

Figure 33-2

How the Phillips Curve Is Related to the Model of Aggregate Demand and Aggregate Supply. This figure assumes a price level of 100 for the year 2000 and charts possible outcomes for the year 2001. Panel (a) shows the model of aggregate demand and aggregate supply. If aggregate demand is low, the economy is at point A; output is low (7,500), and the price level is low (102). If aggregate demand is high, the economy is at point B; output is high (8,000), and the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises when aggregate demand is low, has high unemployment (7 percent) and low inflation (2 percent). Point B, which arises when aggregate demand is high, has low unemployment (4 percent) and high inflation (6 percent).

In panel (b) of the figure, we can see what these two possible outcomes mean for unemployment and inflation. Because firms need more workers when they produce a greater output of goods and services, unemployment is lower in outcome B than in outcome A. In this example, when output rises from 7,500 to 8,000, unemployment falls from 7 percent to 4 percent. Moreover, because the price level is higher at outcome B than at outcome A, the inflation rate (the percentage change in the price level from the previous year) is also higher. In particular, since the price level was 100 in year 2000, outcome A has an inflation rate of 2 percent, and outcome B has an inflation rate of 6 percent. Thus, we can compare the two possible outcomes for the economy either in terms of output and the price level (using the model of aggregate demand and aggregate supply) or in terms of unemployment and inflation (using the Phillips curve).

As we saw in the preceding chapter, monetary and fiscal policy can shift the aggregate-demand curve. Therefore, monetary and fiscal policy can move the economy along the Phillips curve. Increases in the money supply, increases in government spending, or cuts in taxes expand aggregate demand and move the economy to a point on the Phillips curve with lower unemployment and higher inflation. Decreases in the money supply, cuts in government spending, or increases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment. In this sense, the Phillips curve offers policymakers a menu of combinations of inflation and unemployment.

I QUICK QUIZ: Draw the Phillips curve. Use the model of aggregate demand and aggregate supply to show how policy can move the economy from a point on this curve with high inflation to a point with low inflation.

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