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Changes in the AD-AS model and the Phillips curve

Economists who studied the relationship between inflation and unemployment made an important modification to the Phillips curve model with the addition of the long-run Phillips curve (LRPC). When expectations are factored in, and there is enough time to adjust, the Phillips curve is vertical. Explore why in this video.

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Video transcript

- [Instructor] In this video, we're gonna build on what we already know about aggregate demand and aggregate supply, and the Phillips curve, and we are going to connect these ideas. So first, the Phillips curve. This is a typical Phillips curve for an economy. High inflation is associated with low unemployment, high unemployment is associated with low inflation, but we can really view this curve as the short run Phillips curve. Short run Phillips curve. We might sit at different points on this curve at different points in an economic cycle, but we could also introduce an idea known as a long run Phillips curve, which is just based on the natural rate of unemployment for this economy. So let's say the natural rate of unemployment for this economy is 6%. So, then our long run Phillips curve would just be a vertical line right over there. Long run Phillips curve. Now why is it a vertical line? Well it says in the long run, our natural rate of unemployment is 6% regardless of what the inflation rate might be. And so if we are sitting at the intersection of these two curves, that means that our economy right in this moment in time is operating at full employment. If unemployment was lower than that, it would be overheating to some degree, and if unemployment were higher than that, then we would have a negative output gap. But how do we tie these ideas to aggregate demand and aggregate supply? Well let's draw our long run aggregate supply curve, and I'm gonna do it right at the intersection of our aggregate demand and short run aggregate supply curve for now, because I wanna show an economy that's operating at its full potential. So here, this is our long run aggregate supply, and once again it's a vertical line because in the long run, regardless of the price level, we have a certain output for this economy that is sustainable. So that is our full employment. I'll do F, period, E, period. That's our full employment output. Anything more than that, it's unsustainable based on where the economy is structurally right now, and anything less than that, is you have a negative output gap. But now let's think about what would happen if we start shifting curves around. What if we were to have a negative demand shock? So our aggregate demand curve shifts to the left. Well in that world, and this is all a review, you can see that your equilibrium price, so I'm gonna call this aggregate demand sub two, our price level two, and our new equilibrium output for our economy sub two. You can see that both are lower. We now have a negative output gap. But what would that correspond to here on our Phillips curves? Well, when you have a negative output gap, you're likely to have higher unemployment. And shifts in aggregate in the aggregate demand curve would be movements along the short run Phillips curve. So we're gonna move along the short run Phillips curve, and we're going to have higher unemployment, 'cause we have a negative output gap. So we might get to that point right over there. So I'll just call that point sub two. So we went from a situation where before, we had 6% unemployment, and let's say we had 3% inflation, to a world where maybe now, we have, I don't know, let's call it 9% unemployment, and now we have 2% inflation. And it could go the other way around. Let's say we were starting from our original aggregate demand curve and you have a positive demand shock, and so now you could go to this curve, aggregate demand three, and so here, our equilibrium price level is higher. It's called P sub three. And our equilibrium output, we have a positive output gap, so Y sub three. And that would correspond to, if we have a positive output gap, that means we have very low unemployment, maybe unsustainably low unemployment. So we might be right over here. So this might be a situation where our unemployment rate, let's say that's about, I don't know, 4%. And now our inflation, this might be, let's call that 4% as well. And something interesting happens as you start to have higher and higher inflation. That can lead to people just having higher expectations for price and higher expectations for inflation itself. And if folks have higher expectations for inflation, well then they might wanna charge more for a certain level of output. So let's say at this level of output, people might want to have a higher price level. At this level of output, people might wanna have a higher level price, a higher price level. And so it could actually shift our short run aggregate supply up, or you could say to the left. So short run aggregate supply, I'll call that sub three. Now when the short run aggregate supply gets shifted to the left in this situation, notice we're back to our full employment output, but our price level is now much higher. Now what would that correspond to over here? Well when you have a shift in short run aggregate supply curves, that would actually lead to a shift in your short run Phillips curve, but which way would it shift? Well another way to think about it is, at a given, just as at a given level of output you would've expected a higher price because of this increased inflation expectations, so here, at a given level of unemployment, you would expect a higher level of inflation. So, our curve, you would say shifts up or to the right. So we would then have a short run Phillips curve that looks like this. I'll call that sub three. And we might get back to this point. Well for sure if were at this full employment output, then we are operating in our natural rate of unemployment again, but notice, now our inflation has crept even higher. This might be 5% inflation. Now the last thing you might be wondering about is when do these long run curves ever shift? Well we've talked about it before when we talked about long run aggregate supply, and that shifts if the economy structurally changes somehow. Let's say our factories get bombed out in a war or something, then this should shift to the left. And if we got better technology, or better ways of organizing ourselves, or more resources, this might shift to the right. Similarly, if there's a massive shift in global trade, and maybe our workers' skills aren't as valuable anymore in the global economy, this long run Phillips curve might shift to the right. If all of a sudden we are able to, or over time, we're able to get people more skilled, maybe we get frictional unemployment down because we have better technology to place people, well that might shift this to the left.