Summary EC 108 The Phillips Curve Review

The Phillips curve

● Nominal rigidity - nominal wages and prices are fixed
● Equilibrium unemployment = the non-accelerating inflation rate of
unemployment (NAIRU)
○ If unemployment > NAIRU, there is a negative output gap
○ When unemployment = NAIRU, there is no incentive for workers to
increase wage demands or for firms to
increase prices
■ Inflation is constant, not 0
● The equilibrium inflation rate is the long run rate at
which the economy converges
○ Equal to the inflation target
○ No pressure on wages or prices
● Decreases in AS shift the SR Phillips Curve to the
right

Unemployment and Inflation

● Equation of the Phillips curve is 𝛼(𝑌𝑡 − 𝑌𝑒 ) = 𝜋𝑡 − 𝜋𝐸
○ Derived in lecture slides
● Gives an upward sloping Phillips curve when output
is on the x-axis and inflation on the y-axis

Deriving the Phillips curve

● An AD shock increases output and decreases
unemployment
○ Increases nominal wages in the next period, increasing prices
● AD shock causes wage setters to increase wages to reflect the previous
𝛥𝑤 𝛥𝑃
period’s price increase - ( 𝑤 )𝑡 = ( 𝑃 )𝑡−1 + 𝛼(𝑦𝑡 − 𝑦𝑒 ) (wage inflation)
𝛥𝑃 𝛥𝑤 𝛥𝜆
○ Price setters set P to maintain the markup - ( 𝑃 )𝑡 = ( 𝑤 )𝑡 − ( 𝜆 )𝑡 (price
inflation)
● 𝜋𝑡 = 𝜋𝑡−1 + 𝛼(𝑦𝑡 − 𝑦𝑒 )
● Phillips curve always passes through equilibrium output and expected inflation
○ When expected inflation = actual inflation in the previous period
● The MR becomes flatter when the slope of the Phillips curve increases