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Phillips and Laffer Curves

Phillips and Laffer Curves. A.W. Phillips, 1958. Inflation-Unemployment Relationship. Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment caused by changes in AD. AS shocks cause higher rates of inflation higher rates of unemployment.

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Phillips and Laffer Curves

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  1. Phillips and Laffer Curves A.W. Phillips, 1958

  2. Inflation-Unemployment Relationship • Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment caused by changes in AD. • AS shocks cause • higher rates of inflation • higher rates of unemployment. • There is no significant trade-off over long periods of time.

  3. The Phillips Curve Concept 7 6 5 4 3 2 1 0 As inflation declines... Unemployment increases Annual rate of inflation PC 1 2 3 4 5 6 7 Unemployment rate (percent)

  4. INFLATION RATE PRICE LEVEL UNEMPLOYMENT RATE REAL OUTPUT The Phillips Curve Trade-Off √ Increases in AD causes movements along the Phillips Curve. √ As AD changes, the tradeoff between rate of inflation and rate of unemployment moves to a new position on PC. PC AS AD3 Phillips curve AD2 C AD1 C B B A A

  5. The Phillips Curve Trade-OffShort Run Summary √ If Aggregate Demand moves upward, price level rises and Real GDP rises and is reflected as a new point on the short-run Phillips curve showing higher rate of inflation and lower unemployment. √ If AD moves down, price level falls and Real GDP falls and is reflected as a new point on the short-run Phillips curve showing lower rate of inflation and Higher unemployment.

  6. Phillips Curve in the 1960s

  7. Phillips Curve Shifting in the 70s and 80s

  8. Phillips “Curl” Unemployment got worse but so did inflation.

  9. AS3sr AS2sr ASsr PL3 Price Level PL2 PL1 AD1 o Y3 Y2 Y1 Real domestic output Aggregate Supply and Shifting Views Adverse supply shocks can cause periods of rising unemployment and rising inflation. Rapid and significant increases in resource prices push Aggregate Supply to the left.

  10. Historical Evidence √ The OPEC-induced price increases for oil in the 1970’s and the agricultural problems, depreciated dollar, a rise in wages following the wage-price control and declining productivity of mid 70’s announced STAGFLATION. √ In the later 80 and 90’s, the effect of high unemployment and hence smaller increases in wages were coupled with foreign competition that held down prices and wages. Deregulation and the decline of OPEC’s power pushed the rates back closer to the earlier tradeoff picture. The ASsr shifted back to its old position and the ASlr adjusted.

  11. AS3sr AS2sr 7 6 5 4 3 2 1 0 ASsr PL3 Price Level Annual rate of inflation PL2 PC3 PL1 PC2 AD1 PC1 o 1 2 3 4 5 6 7 Y3 Y2 Y1 Unemployment rate (percent) Real domestic output Changes in AS move the Phillips Curve

  12. Phillips Curve Long Run AD changes move along the Philllips Curve AS changes move the Phillips Curve 15% SRPC3 LRPC 12% b3 SRPC2 9% Inflation Rate a3 b2 SRPC1 6% PC3 a2 b1 a1 3% PC2 Inflat. Gap Recess. Gap PC1 0 2% 4% 6% 8% 10% Unemployment Rate

  13. Phillips Curve Long Run Increases in AD beyond full employment temporarily boost profits, output and employment. (a1 to b1). Nominal wages eventually catch up to sustain real wages; profit fall, canceling the short-run effect with employment returning to its full employment level.(b1 to a2), but at higher inflation. 3. The cycle starts again as AD grows, profits grow and employment rises (a2 to b2) 4. Again, in time, nominal wages catch up and employment returns to its natural rate. The reward is a higher inflation rate.

  14. The Phillips Curve —Long Run Summary √ The long-run Phillips curve is the vertical line through a1, a2, and a3 at the natural rate of unemployment. √ Any rate of inflation is consistent with the 5% natural rate of unemployment. √ After all nominal wage adjustments to increases or decreases in inflation have occurred, the economy ends up back at full-employment natural rate position.

  15. SUPPLY SIDE ECONOMICS • AS is what determines inflation, growth and unemployment • High tax rates----hurt productivity, reduce savings/investment • Also: discourage econ activity • Tax evasion • Low tax rates (for businesses) encourage investment • Encourage work, savings • Rewards for consumers who save decreases with higher marginal tax rates • Encourage people to enter labor force reducing unemployment • Increasing productivity • AS expands and keeps inflation low

  16. THE LAFFER CURVE 100 Tax rate (percent) l 0 Tax revenue (dollars)

  17. THE LAFFER CURVE 100 n Tax rate (percent) m l 0 Tax revenue (dollars)

  18. THE LAFFER CURVE 100 n Tax rate (percent) m m Maximum Tax Revenue l 0 Tax revenue (dollars)

  19. CRITICISMS OF THE LAFFER CURVE • Economic incentives don’t have as large an impact • Demand-side effects of a tax cut exceeds the supply-side effects • 1980—Reganominces supported Laffer • Tax decreased from 50-28% and productivity increased

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