Question

Describe the concept of Phillips curve and how it can be used to examine the shifts of the aggregate supply curve in the AD‐AS model.

Answer 1

Phillips curve shows short run inverse trade off between unemployment rate & inflation rate, for a given expected inflation rate.

As high growth rate in AD stimulates output, so spending rise, output rise, employement rise, & hence unemployment falls, thus higher spending pushes inflation up.

Thus lower unemployment rate can be achieved only at cost of higher inflation rate.

In long run, no tradeoff between unemployment & inflation exists, so long run PC is vertical line at natural unemployment rate.

explanation via AD-AS.

Let initial equilibrium is at A,, where in SR, AS & AD intersect. Let govt boosts the Economy, by holding Aggregate Demand, so AD curve shifts to right .

Since expansionary fiscal policy is followed, so both employement & output rises, new equilibrium at point B.

So unemployment falls,,we move upwards along the original SRPC1, Phillips curve , from A to B,

Price level rise, so inflation rise .

Now in short run, no change in AS curve, but since prices have increased, but no change in nominal wages, thus real wages of workers fall.

Workers or Labor are unable to take in to account this fall in real wages , but they can't be made fooled in long run, bcoz they realise a cut in real wages & hence Purchasing power, so they demand hike in nominal wages,

So they cut down their Labor supply, hence AS curve shifts upwards , new equilibrium at C, where new AD & AS curve cuts .

since now workers take into account the increased inflation & revise their inflationary expectations, so economy shifts to new SRPC2, at higher expected inflation rate.

so movement from B to C.

thus in long run, price level rise permanently, but output level is at its natural equilibrium level .