Short Run Phillips Curve - Online Tutor, Practice Problems & Exam Prep

Deriving the Short Run Phillips Curve; Unemployment and Inflation

One of the most important relationships we learn in this course is that between unemployment and inflation. Here we're going to use the Phillips curve to help us visualize that relationship. So, we're going to be focused on unemployment and inflation here. Okay? And it's very hard to control these two variables. Right? Ideally, we would have low inflation and low unemployment. That sounds like a good situation. However, they have this what we're going to call an inverse relationship. So, inverse relationship meaning if we try and control inflation and bring price levels down, well, unemployment is going to go up and vice versa. If we try and keep unemployment low, inflation is going to go up. So, we'll see how that works, but on a high level, when we think about our aggregate demand ADAS model, aggregate demand aggregate supply model, well, if aggregate demand increases, so we have our equilibrium and aggregate demand increases to a new equilibrium. At this new equilibrium, we have a higher price level. And because of this higher aggregate demand, there's a higher equilibrium GDP. And to create that GDP, we need more workers, so unemployment goes down in that sense, right? So, you can see this inverse relationship. The aggregate demand increasing leads to higher price levels and it leads to more GDP, which means higher employment or lower unemployment. Okay? And the opposite, if aggregate demand decreases, well, it's the opposite situation. Lower aggregate demand brings the price levels down, but unemployment goes up because there's not as much demand for products. So, there's they don't need the workers to create them. Okay? So, unemployment will go up. So, let's see how this works in the ADAS model and then we're going to draw our short-run Phillips curve here. Okay? So, assume it's the first assume year 1 just passed and there was a price level of 100. It's going to be the easiest way to visualize this. If we start at 100 and see what happens in the next year, we're going to see how the short-run Phillips curve can be derived. Okay? So, we're going to be analyzing situations for year 2. Okay? So, there could be 2 situations, let's say in year 2. There could be low aggregate demand or high aggregate demand, okay? So, that's what I've got here on the graph. Are two possibilities for aggregate demand and we're going to derive our Phillips Curve from this. Okay? So, we have our short-run aggregate supply here and depending on what aggregate demand is like, is where our equilibrium is going to be. So, let's say we're at this low aggregate demand and we have this equilibrium right here. So, remember in this price in this model, we've got the price level over here which represents inflation. And we're going to have our GDP on this x-axis which is where we're going to derive our unemployment from. The idea is with unemployment and GDP is that when we need to when we're producing more stuff, we need to hire more workers, right? So, that's the relationship between GDP and unemployment. The more stuff we're producing, the more employment we have or less unemployment. So, let's say we're at this lower aggregate demand and we see that the price level in year 2 is 100 2, right? So, it was 100 in the 1st year and 102 in the 2nd year. So, this means there was approximately 2%. Well, not approximately, there was 2% inflation, right? From year 1 to year 2, we saw 2% inflation there. Now, let's say, we're in this higher situation. We're in the higher aggregate demand and we're somewhere up here. So, this is our equilibrium at the higher aggregate demand. And this would be our equilibrium GDP down there. We'll get to those in a second. But in this case, let's say we have, a price level of 106 because of this higher aggregate demand, right? So, it's a higher price level. I'm just making up these numbers so that we can kind of visualize it in our short-run Phillips curve. So, this would be a situation where we have 6% inflation from year to year, right? It was 100 last year, now it's 106 in the 2nd year. So, this was year 1 right here. We assumed was a 100, the base year and now, we're looking at year 2. What could happen? So, it'd be 106 in this situation. Okay. So, you could see as at this higher aggregate demand, we've got a higher price level Just like we set up here, right? Aggregate demand increases, so a higher aggregate demand, higher price level, right? So, that's how we derive that. Now, let's look at the unemployment side, the side about GDP. So, at this low aggregate demand, we'll have this output right here. Let's say this output is 15,000, okay? There's $30,000 worth of GDP. Of course, that's a small number for a huge country, but let's keep the number simple. So, 15,000 of GDP there, and at the higher aggregate demand, our equilibrium is say 16,000 GDP. So, which of these GDP levels do you think we have more employment? How many in which situation are more people employed? The higher situation, right? When we want to have more GDP, we need more people employed to produce that. So higher employment means lower I'm gonna put UE for unemployment. Let's say unemployment in this situation, we'll say is 4%. We're just making up a number there. And unemployment in this situation, well, if there's there's less GDP, less stuff is being created, they need fewer workers to create it. We'll say it's 7% in this situation when we have 15,000 GDP. Alright? So now, let's go over to this graph on the right. Let me get out of the way and we're going to do our short-run Phillips Curve. So, what we're seeing here is we're going to have inflation, the inflation rate on the y-axis and the unemployment rate on the x-axis and what we're going to do is we're going to graph these two situations over here. So, when aggregate demand was high when aggregate demand was high, we had an inflation rate of 6%. So, we'll say inflation of 6% was somewhere up here 6%. And we had an unemployment rate over here. At this point, our unemployment rate was 4%. Unemployment was 4%. So, we'll say 4% is around here. And we'll put that point on the graph. Okay? So, this is the point where with aggregate demand high. Right? With the high aggregate demand, we had that point on the graph. And now, in the other situation, we had a low price level. So, we had 2% inflation. Notice prices are still going up, right? We still have inflation in this situation. Prices are still going up since last year, but not as much. So, 2% inflation, but we've got more unemployment, right? At this point, we had less GDP, meaning fewer people were employed to create it. So, we were up here, somewhere around here with our with our unemployment and we end up somewhere around here. Okay? So, if we were to connect these dots, we're going to see our short-run Phillips curve. It would look something like this. So, this is our short-run Phillips curve. So, notice, this is different than other curves we've looked at because our axes are unemployment rate and inflation rate. Usually, we're dealing with some sort of price and quantity on the axes. In this case, we're comparing the inflation rate and unemployment rate. And when we see this downward slope like this, it means there's an inverse relationship. Just like the inverse relationship we had with demand, right? As prices go up, quantities go down. As prices go down, the quantity demanded goes up. The same thing here. As the inflation rate decreases, the unemployment rate increases. As the unemployment rate decreases, the inflation rate increases. And that's that inverse relationship I was telling you about and that's why it's difficult to control both inflation and unemployment at the same time. Alright, so that's our short-run Phillips Curve. It describes that relationship between unemployment and inflation. Okay? That's what we use it for. And we can make some cool analyses out of this curve as well. So, what did we see happening? This is the key thing to remember about this curve is that as inflation increases, unemployment decreases. And as inflation decreases, unemployment increases. Okay? The inverse relationship. I'm a write it here one more time. Inverse relationship. Alright. So that's our short-run Phillips curve. Let's go ahead and move on to the next video.