Understanding the Short-Run Phillips Curve

Hi everyone, in this video we're going to tackle the Phillips Curve, specifically just the short run Phillips Curve. Before I get started, let me explain what the Phillips Curve is useful for in your course. Now, what the Phillips Curve... tells us is something that we already know, something we've already learned using basic models to show inflation, demand pull or cost push inflation, but also to show long term equilibrium using the classical model. That's basically what the Phillips curve shows us. us but in a very different way. So when it comes to an exam, it's unlikely you're going to get a very specific question on the Phillips Curve. You might do, but unlikely. Chances are you can use the Phillips Curve to show what you already know, demand pool, cost push inflation and long-term equilibrium according to the classical model. So bear that in mind. It's also very useful to show the conflict between inflation and unemployment. So any time you're making that point in an essay, you can bring in the Phillips Curve to substantiate your point and to add weight to it. to your point. But it doesn't really tell us anything new, so bear that in mind as we go through this theory. Okay, so the Phillips Curve. We're going to look at the short-run Phillips Curve. Phillips was a New Zealand economist who kind of made his name when working for the London School of Economics. And he came out with this theory in the late 1950s, early 1960s, mapping the relationship between wages and unemployment. And he just did a very simple correlation analysis, looking at data going back over a hundred years. hundred years or so to look at what was going on between wage growth and unemployment in the economy. He came up with this relationship when plotting lots of points and using the line of best fit. He came up with this curve, a downward sloping curve to make reference to the inverse relationship between wage growth and unemployment. And he said, well, in times of very low unemployment down here, wages were rising very quickly. And that makes sense because when unemployment is low, workers are scarce. They have more bargaining power to push up wages. wages. That's a natural relationship we'd expect there. Whereas in times of high unemployment, it makes sense that wages or wage growth would be falling, and even maybe becoming negative as workers took paid cuts during times of high unemployment when workers were plentiful in supply, putting downward pressure on wages. So he came up with this relationship, which makes a lot of sense, but economists actually took that one stage further. Instead of looking at wage growth on the... y-axis we can actually put inflation rate instead and that's in percent of course and economists said was it's fair enough for us to change wage growth to inflation rate because in the 1960s when this theory came about when this model came about firms were very labor-intensive so if there were changes in wages it was likely that that would feed directly through to changes in the inflation rate so wage growth was increasing quite quickly, chances were that inflation would increase very quickly at the same time. So it was not too assumption-based to change wage growth to inflation rate. And this is something we should be aware of already. Now you know that during times of low unemployment, when the economy is close to full employment and AD keeps shifting to the right to get us there, you know that a side effect of an increase in growth and a reduction in unemployment is higher inflation, high demand. You would have studied that and learnt that on a diagram. The Phillips Curve tells us exactly the same thing. What it tells us is that there is a conflict between unemployment and inflation. And this is a big problem for policy makers. And you can see why politicians didn't like what the Phillips Curve was saying. So SRPC here stands for Short-Rope Phillips Curve. And it shows that if you want to have low unemployment, so down here, low unemployment, you have to sacrifice your inflation objective. You can't have low and stable... at the same time, you're going to suffer from higher rates of inflation. Hmm, problem, conflict. Whereas, if you want to have low levels of inflation, low unstable inflation rates, you have to sacrifice your unemployment target. You must, as a politician, sacrifice unemployment and deal with high unemployment, unfortunately. That's the conflict that the short-run Phillips curve is saying here. And that conflict can be derived from what's happening to aggregate demand. So, a lot of the Phillips curve theory stems from what classic economists have said Classical economics tells us. Classical aggregate demand, aggregate supply models tell us. If you're not sure about the classical model, watch my very detailed video on that to understand it. Let's show the classical model here to understand this conflict. So we'll take price level and real GDP. Let's take an economy that is at the full employment level of output. for the price level of P1. On our Phillips curve, let's map that across. So on our Phillips curve, that point there, let's put an actual inflation number. That could well be 2% unemployment. And if we keep going across... That takes us to point A, which let's say represents 5% unemployment, which is the natural rate of unemployment. So remember, at full employment, that doesn't mean that unemployment is zero. It means there is still some structural unemployment, frictional seasonal unemployment. There is still going to be some unemployment there. So the natural rate represents the unemployment level when the labour market is at equilibrium. And the only unemployment that can exist there, supply side, is structural, seasonal, frictional. So 5% unemployment and with that you have a low and stable rate of inflation, let's say at 2%. Right, okay. What the Phillips Curve says is that let's say we want to increase growth and reduce unemployment. Well, we're going to suffer from higher inflation. at the same time. And that can be shown here by shifting AD to the right. So let's say we shift AD from AD1 to AD2. In the short term, in the classical model, that increases growth and that will reduce unemployment below the natural rate, but at a cost of higher inflation. And if we go to our Phillips curve, that's exactly what's being shown here. So we move to point B, and point B will represent higher inflation, maybe that's down 3%, and lower unemployment below the natural rate, maybe of 4%. Yes, you benefit from lower unemployment as growth increases in the short term, but you have to suffer from higher rates of inflation beyond your target rate. So on the Phillips curve, when 80 shifts to the right, we move up the Phillips curve. Let's say 80 shifts to the left from 81 to 83. In a classical model, output falls to Y3 and inflation falls to P3. So when it comes to unemployment, we know unemployment will rise beyond the natural rate. So again, we map that point across. Maybe that's inflation falling to 1%. here, but if we keep going across, we end up at point C, as we can see here, that unemployment is increasing, maybe to 70%. So there's the conflict right there. You're seeing a benefit in terms of lower inflation, but you're suffering from higher unemployment at the same time. And that's the basic conflict we're used to when aggregate demand shifts left and right. So what to take away from here? Well, whenever aggregate demand shifts right or left, there is a movement along the Phillips curve. If aggregate demand shifts to the left, there to the right, we move up the Phillips curve, representing higher inflation, lower unemployment. Whereas if aggregate demand shifts to the left, we move down the Phillips curve from A to C in this diagram to represent higher unemployment but lower inflation. So whenever AD shifts, we move along the short-run Phillips curve. That's the key thing to take away. So in that sense, we can use the short-run Phillips curve to represent demand and inflation too, and how demand and inflation can increase and decrease according to shifts of AD, as has been shown here. So useful to show the conflict between inflation and inflation. inflation and unemployment, yes, but also to show demand for inflation, according to A.D. Chang. Now that was the basic idea of Phillips. That's where he comes stopped in his theoretical understanding. However, monetarists, classical economists like Milton Friedman, decided that that basic model was not good enough. It didn't actually tell us and explain periods where an economy can be suffering from high inflation and high unemployment, known as stagflation. Why could that be shown on the Phillips scale? curve? Nowhere. So therefore, the Phillips curve was adapted in the short run to also shift. Right, at the moment, the problem with this Phillips curve is that it doesn't explain how we can have periods of stagflation, where unemployment can be very high, so it'll be here somewhere, and inflation at the same time can be very high. It doesn't explain that at all, right? According to the Phillips curve, you can either only have lower unemployment with high inflation, or low inflation with higher unemployment. Where is higher unemployment in high inflation? Well, classical economists have changed, adapted the model to actually account for periods of stagflation. And they said, well, let's take a negative supply-side shock, which could shift SRAS to the left, from SRAS1 to SRAS2. Well, as can be shown, there's the increase in inflation and there's the increase in unemployment at the same time, as output falls from Yv to Y2. Now, if we go across to our Phillips curve... There's point A. We started at point A. Take the same figures, 2% inflation and the natural rate of unemployment. Call it 5%. Going across and going up our Phillips curve, yes, we can show the higher inflation that's been... caused by this negative supply-side shock. Maybe that's an increase in oil prices, an increase in a sudden increase in wages maybe, maybe it's a sudden increase in import prices, whatever it might have done, a shock to the economy that increases, that shifts SRAS from SRAS1 to SRAS2, an increase in inflation. Yes, that's being shown on the diagram here, but apparently unemployment will fall, and that's not what's being shown on this diagram here. So, monetarists said no. When SRAS shifts, when there is a negative supply-side shock, the FIPS... And it shifts the opposite way to the shift of SRAS. So from SRPC1 to SRPC2. And now if we move across, you will see that the economy moves to point B. which represents a higher rate of inflation, and then call it 3%, but also a higher rate of unemployment, more than the natural rate of let's say 6% here. Okay, so the economy moves from point A to point B, shifts to a new short-run Phillips curve. What about positive supply-side shock? Maybe that's a fall in the oil price. Well, in the classical model, that will increase output to Y2 in the short run and reduce cost-push inflation to P2. Again, if we go across to our Phillips curve. that wouldn't be being shown on SRPC1 at all. SRPC1 will tell us, yeah, as you move down it, fair enough, there is a reduction in inflation. But apparently there is going to be an increase in unemployment. That's not what's being shown on this diagram. So we shift the short run Phillips curve, this time to the left. To SRPC3. And what we see here is if we move across on this new Fibs curve, yeah, there might be lower inflation at point C, but there is a reduction in unemployment as well, below the natural rate of unemployment. at 4%, which is exactly what's being shown here. So the key thing to take away is that through the adaptation of the short-run Phillips curve by monetarists, stagflation can be shown here. When a supply-side shock takes place, the short-run Phillips curve... shifts in the opposite direction to which the short run aggregate supply curve shifts. So if SRAS shifts to the left, a negative supply side shock, the SRPC will shift to the right. And that's how we can show stagflation. So point B here represents stagflation, overcoming a major limitation of the basic short run Phillips curve done on the previous diagram. Now stagflation can be shown as well, which represents periods of higher inflation and higher levels of unemployment. So we can also... We can also show cost push inflation using the short run Phillips curve by shifting it left or right according to changes in cost of production when SRES changes. In this video we've shown how we can use the Phillips curve in three different ways. To show demand for inflation, moving up or down the Phillips curve, show cost push inflation, shifting the Phillips curve left and right, and to show the basic conflict between inflation and unemployment when aggregate demand changes in the economy. Now, monetary still fundamentally disagreed with this model or found major limitations. limitations with this model even as it stands right now because it doesn't actually show long-term equilibrium. The classical model will actually show how the economy can move back to full employment levels without putting the long term. No such indication is being shown on this short-run Phillips curve. That understanding is not being shown hence it's limited. So the monetarist adapted this model further and in my next video I'll show how the long-run Phillips curve can be derived. Until then, see you later. Thank you.

tells us is something that we already know, something we've already learned using basic models to show inflation, demand pull or cost push inflation, but also to show long term equilibrium using the classical model. That's basically what the Phillips curve shows us. us but in a very different way. So when it comes to an exam, it's unlikely you're going to get a very specific question on the Phillips Curve. You might do, but unlikely.

Chances are you can use the Phillips Curve to show what you already know, demand pool, cost push inflation and long-term equilibrium according to the classical model. So bear that in mind. It's also very useful to show the conflict between inflation and unemployment. So any time you're making that point in an essay, you can bring in the Phillips Curve to substantiate your point and to add weight to it. to your point.

But it doesn't really tell us anything new, so bear that in mind as we go through this theory. Okay, so the Phillips Curve. We're going to look at the short-run Phillips Curve. Phillips was a New Zealand economist who kind of made his name when working for the London School of Economics. And he came out with this theory in the late 1950s, early 1960s, mapping the relationship between wages and unemployment.

And he just did a very simple correlation analysis, looking at data going back over a hundred years. hundred years or so to look at what was going on between wage growth and unemployment in the economy. He came up with this relationship when plotting lots of points and using the line of best fit. He came up with this curve, a downward sloping curve to make reference to the inverse relationship between wage growth and unemployment.

And he said, well, in times of very low unemployment down here, wages were rising very quickly. And that makes sense because when unemployment is low, workers are scarce. They have more bargaining power to push up wages. wages.

That's a natural relationship we'd expect there. Whereas in times of high unemployment, it makes sense that wages or wage growth would be falling, and even maybe becoming negative as workers took paid cuts during times of high unemployment when workers were plentiful in supply, putting downward pressure on wages. So he came up with this relationship, which makes a lot of sense, but economists actually took that one stage further. Instead of looking at wage growth on the... y-axis we can actually put inflation rate instead and that's in percent of course and economists said was it's fair enough for us to change wage growth to inflation rate because in the 1960s when this theory came about when this model came about firms were very labor-intensive so if there were changes in wages it was likely that that would feed directly through to changes in the inflation rate so wage growth was increasing quite quickly, chances were that inflation would increase very quickly at the same time.

So it was not too assumption-based to change wage growth to inflation rate. And this is something we should be aware of already. Now you know that during times of low unemployment, when the economy is close to full employment and AD keeps shifting to the right to get us there, you know that a side effect of an increase in growth and a reduction in unemployment is higher inflation, high demand.

You would have studied that and learnt that on a diagram. The Phillips Curve tells us exactly the same thing. What it tells us is that there is a conflict between unemployment and inflation. And this is a big problem for policy makers.

And you can see why politicians didn't like what the Phillips Curve was saying. So SRPC here stands for Short-Rope Phillips Curve. And it shows that if you want to have low unemployment, so down here, low unemployment, you have to sacrifice your inflation objective.

You can't have low and stable... at the same time, you're going to suffer from higher rates of inflation. Hmm, problem, conflict.

Whereas, if you want to have low levels of inflation, low unstable inflation rates, you have to sacrifice your unemployment target. You must, as a politician, sacrifice unemployment and deal with high unemployment, unfortunately. That's the conflict that the short-run Phillips curve is saying here.

And that conflict can be derived from what's happening to aggregate demand. So, a lot of the Phillips curve theory stems from what classic economists have said Classical economics tells us. Classical aggregate demand, aggregate supply models tell us. If you're not sure about the classical model, watch my very detailed video on that to understand it. Let's show the classical model here to understand this conflict.

So we'll take price level and real GDP. Let's take an economy that is at the full employment level of output. for the price level of P1. On our Phillips curve, let's map that across. So on our Phillips curve, that point there, let's put an actual inflation number.

That could well be 2% unemployment. And if we keep going across... That takes us to point A, which let's say represents 5% unemployment, which is the natural rate of unemployment. So remember, at full employment, that doesn't mean that unemployment is zero.

It means there is still some structural unemployment, frictional seasonal unemployment. There is still going to be some unemployment there. So the natural rate represents the unemployment level when the labour market is at equilibrium. And the only unemployment that can exist there, supply side, is structural, seasonal, frictional.

So 5% unemployment and with that you have a low and stable rate of inflation, let's say at 2%. Right, okay. What the Phillips Curve says is that let's say we want to increase growth and reduce unemployment. Well, we're going to suffer from higher inflation. at the same time.

And that can be shown here by shifting AD to the right. So let's say we shift AD from AD1 to AD2. In the short term, in the classical model, that increases growth and that will reduce unemployment below the natural rate, but at a cost of higher inflation.

And if we go to our Phillips curve, that's exactly what's being shown here. So we move to point B, and point B will represent higher inflation, maybe that's down 3%, and lower unemployment below the natural rate, maybe of 4%. Yes, you benefit from lower unemployment as growth increases in the short term, but you have to suffer from higher rates of inflation beyond your target rate.

So on the Phillips curve, when 80 shifts to the right, we move up the Phillips curve. Let's say 80 shifts to the left from 81 to 83. In a classical model, output falls to Y3 and inflation falls to P3. So when it comes to unemployment, we know unemployment will rise beyond the natural rate. So again, we map that point across. Maybe that's inflation falling to 1%.

here, but if we keep going across, we end up at point C, as we can see here, that unemployment is increasing, maybe to 70%. So there's the conflict right there. You're seeing a benefit in terms of lower inflation, but you're suffering from higher unemployment at the same time. And that's the basic conflict we're used to when aggregate demand shifts left and right. So what to take away from here?

Well, whenever aggregate demand shifts right or left, there is a movement along the Phillips curve. If aggregate demand shifts to the left, there to the right, we move up the Phillips curve, representing higher inflation, lower unemployment. Whereas if aggregate demand shifts to the left, we move down the Phillips curve from A to C in this diagram to represent higher unemployment but lower inflation.

So whenever AD shifts, we move along the short-run Phillips curve. That's the key thing to take away. So in that sense, we can use the short-run Phillips curve to represent demand and inflation too, and how demand and inflation can increase and decrease according to shifts of AD, as has been shown here. So useful to show the conflict between inflation and inflation. inflation and unemployment, yes, but also to show demand for inflation, according to A.D.

Chang. Now that was the basic idea of Phillips. That's where he comes stopped in his theoretical understanding. However, monetarists, classical economists like Milton Friedman, decided that that basic model was not good enough. It didn't actually tell us and explain periods where an economy can be suffering from high inflation and high unemployment, known as stagflation.

Why could that be shown on the Phillips scale? curve? Nowhere.

So therefore, the Phillips curve was adapted in the short run to also shift. Right, at the moment, the problem with this Phillips curve is that it doesn't explain how we can have periods of stagflation, where unemployment can be very high, so it'll be here somewhere, and inflation at the same time can be very high. It doesn't explain that at all, right?

According to the Phillips curve, you can either only have lower unemployment with high inflation, or low inflation with higher unemployment. Where is higher unemployment in high inflation? Well, classical economists have changed, adapted the model to actually account for periods of stagflation. And they said, well, let's take a negative supply-side shock, which could shift SRAS to the left, from SRAS1 to SRAS2. Well, as can be shown, there's the increase in inflation and there's the increase in unemployment at the same time, as output falls from Yv to Y2.

Now, if we go across to our Phillips curve... There's point A. We started at point A.

Take the same figures, 2% inflation and the natural rate of unemployment. Call it 5%. Going across and going up our Phillips curve, yes, we can show the higher inflation that's been...

caused by this negative supply-side shock. Maybe that's an increase in oil prices, an increase in a sudden increase in wages maybe, maybe it's a sudden increase in import prices, whatever it might have done, a shock to the economy that increases, that shifts SRAS from SRAS1 to SRAS2, an increase in inflation. Yes, that's being shown on the diagram here, but apparently unemployment will fall, and that's not what's being shown on this diagram here. So, monetarists said no.

When SRAS shifts, when there is a negative supply-side shock, the FIPS... And it shifts the opposite way to the shift of SRAS. So from SRPC1 to SRPC2.

And now if we move across, you will see that the economy moves to point B. which represents a higher rate of inflation, and then call it 3%, but also a higher rate of unemployment, more than the natural rate of let's say 6% here. Okay, so the economy moves from point A to point B, shifts to a new short-run Phillips curve.

What about positive supply-side shock? Maybe that's a fall in the oil price. Well, in the classical model, that will increase output to Y2 in the short run and reduce cost-push inflation to P2.

Again, if we go across to our Phillips curve. that wouldn't be being shown on SRPC1 at all. SRPC1 will tell us, yeah, as you move down it, fair enough, there is a reduction in inflation. But apparently there is going to be an increase in unemployment.

That's not what's being shown on this diagram. So we shift the short run Phillips curve, this time to the left. To SRPC3. And what we see here is if we move across on this new Fibs curve, yeah, there might be lower inflation at point C, but there is a reduction in unemployment as well, below the natural rate of unemployment.

at 4%, which is exactly what's being shown here. So the key thing to take away is that through the adaptation of the short-run Phillips curve by monetarists, stagflation can be shown here. When a supply-side shock takes place, the short-run Phillips curve... shifts in the opposite direction to which the short run aggregate supply curve shifts. So if SRAS shifts to the left, a negative supply side shock, the SRPC will shift to the right.

And that's how we can show stagflation. So point B here represents stagflation, overcoming a major limitation of the basic short run Phillips curve done on the previous diagram. Now stagflation can be shown as well, which represents periods of higher inflation and higher levels of unemployment. So we can also... We can also show cost push inflation using the short run Phillips curve by shifting it left or right according to changes in cost of production when SRES changes.

In this video we've shown how we can use the Phillips curve in three different ways. To show demand for inflation, moving up or down the Phillips curve, show cost push inflation, shifting the Phillips curve left and right, and to show the basic conflict between inflation and unemployment when aggregate demand changes in the economy. Now, monetary still fundamentally disagreed with this model or found major limitations. limitations with this model even as it stands right now because it doesn't actually show long-term equilibrium. The classical model will actually show how the economy can move back to full employment levels without putting the long term.

No such indication is being shown on this short-run Phillips curve. That understanding is not being shown hence it's limited. So the monetarist adapted this model further and in my next video I'll show how the long-run Phillips curve can be derived. Until then, see you later.

Thank you.

Transcript for:Understanding the Short-Run Phillips Curve

Transcript for:
Understanding the Short-Run Phillips Curve