The Phillips Curve: SRPC, LRPC, and Connections

Short Run Aggregate Supply (SRLAS)

• Time too short for wages to adjust to the price level

              -Because workers may not be aware of changes in their real wages due to inflation, therefore they adjust their labor decisions accordingly as well as wage demands.

Nominal Wage

• Amount of money received per day, per hour, per year.

Real Wage

• Adjusted for inflation, taxes, etc.

Long Run Aggregate Supply (LRAS)

• Time long enough for wages to adjust to the price level

             -Key Assumptions

                   1) Wage and Price is flexible

                   2) Changes in Wage and Price offset each other

                   3) LRAS represented by a vertical line

                   4) LRAS is effected by the same elements that shift PPC

Phillip's Curve (deals with Inflation and Unemployment)

• Generalizations:

           1) Inverse relationship between inflation and unemployment

           2) Aggregate Supply shocks can cause both higher rates of inflation and higher rates of unemployment

           3) No significant trade-off between inflation and unemployment in the long-run

Short Run Phillips Curve

• If inflation persists and the expected rate of inflation rises, then the entire SRPC moves upward (stagflation is possible/probable)
• If inflation expectations drop due to new technology then the SRPC moves downward

Long Run Phillips Curve

• vertical at full employment
• Major Assumptions:

            -More worker benefits create higher natural rate of unemployment and fewer worker benefits create lower natural rates of unemployment

            -LRPC shifts due to advances in technology (same as LRAS)

Misery Index

• Combination of Inflation and unemployment in a given year; single digit misery is good

Supply Shock

• Rapid and significant increase n resource prices which cause the SRAS to shift, which results in producing a shift in the SRPC curve

                -Example: oil embargo, increase in input prices, wage heights

• Can be positive or negative
• Can lead to stagflation: simultaneous increase in inflation and unemployment

Disinflation

• Reductions in the inflation rate from year to year, which can be seen in the long run Phillips Curve

Supply-Side Economics (Reagonomics)

• Tends to believe that the AS Curve will determine levels of inflation, unemployment, and economic growth.

              -To increase economy shift AS ->

                    *Company benefits first in AS

• Focus on Marginal tax rate-amount of tax paid on an additional dollar of income
• Reducing Marginal tax rates, it will encourage more people to work longer; high marginal tax rates may end up reducing savings since when you save money, you are then taxes at a higher rate on your profit or investment

Laffer Curve

• 3 Criticisms:

           1) Where the economy is actually located on the curve is difficult to determine

           2) Tax cuts also increase Demand, which can fuel inflation and Demand may exceed supply

           3) Research states, that tax rates impact people's incentive to work, invest, and save

• As tax rates increase from zero, tax revenues increase from zero to some max value, then they decline