1. Inflation, Unemployment,
and the Phillips Curve
How the Phillips curve
demonstrates the inflation-
unemployment tradeoff that
policy makers face.

2. Building the Phillips Curve
The Phillips curve
states that inflation
depends on expected
inflation…
( )e n
u u vπ π β= − − +
the deviation of
unemployment from the
natural rate (cyclical
unemployment)…
and supply shocks.

3. Building the Phillips Curve
(1/ )( )e
P P Y Y vα= + − +
(1/ )( )e
P P Y Yα= + −
1 1( ) (1/ )( )e
P P P P Y Y vα− −− = − + − +
The Phillips curve is derived
from aggregate supply.
First we add an exogenous
supply shock term to the right
hand side.
Then we subtract last year’s
price level P-1 from both sides.
(1/ )( )e
Y Y vπ π α= + − +We can write inflation as
π=(P–P-1) and expected
inflation as πe
=(Pe
–P-1).
Recall Okun’s law. Which states that
deviation of output from its natural rate
is inversely related to deviation of
unemployment from its natural rate.
(1/ )( ) ( )n
Y Y u uα β− = − −
( )e n
u u vπ π β= − − +
By substituting we obtain the
Phillips curve.

4. Building the Phillips Curve
• So the Phillips curve and the short run aggregate
supply curve essentially represent the same
economic ideas.

5. Adaptive Expectations and Inflation Inertia
• The Phillips curve shows the trade-off facing policy makers
in terms of unemployment and inflation.
• To make the Phillips curve more useful we need to say what
causes expected inflation.
1
e
π π−=A simple and plausible assumption might
be that people form expectations about
future inflation based on recent inflation.
In this case, we can write the
Phillips curve as...
1 ( )n
u u vπ π β−= − − +
which states that inflation
depends on past inflation,
cyclical unemployment, and a
supply shock.
The first term in the Phillips curve
implies that inflation has inertia and that
inflation keeps going unless something
acts to stop it. In essence we have
inflation because we expect it and we
expect it because we have it.

6. Inertia in AD-AS
• In the AD-AS
framework inflation
inertia is
characterized by
persistent upward
shifts of both AD and
AS.
P
Q
AS
AD
Aggregate supply shifts up
because of expected inflation.
Most often the upward shifting
aggregate demand curve is caused
by persistent growth in the money
supply.

7. Inertia in AD-AS
P
Y
AS
AD
If prices have been rising quickly,
people will expect them to continue to
do so. Because AS depends on
expected inflation the AS curve will
continue to shift upward.
(1/ )( )e
P P Y Yα= + −
It will continue to shift upward until
some event, such as a recession or a
supply shock, changes inflation and
thereby changes expectations of
inflation.
If for example the central bank
tightened the money supply, AD
would shift back.
This would cause a recession.
High unemployment would
reduce inflation and expected
inflation, causing inflation inertia
to subside.
Suppose the central bank is pursuing
an expansionary monetary policy
causing AD to shift out.
AS would stop
shifting up.

8. Two Causes of Rising and Falling Inflation
1 ( )n
u u vπ π β−= − − +
The second term shows that
cyclical unemployment exerts
upward or downward pressure
on inflation. Low
unemployment pulls inflation
up. This is called demand-
pull inflation because high
AD is the cause.
The third term shows that
inflation also rises and
falls with supply shocks.
An adverse supply shock
would push production
prices up. This type of
inflation is called cost-
push inflation.

9. The Short Run Tradeoff Between Inflation and
Unemployment
• While expected inflation and
supply shocks are beyond the
policy maker’s control, in the
short-run the policy maker can use
monetary or fiscal policy to shift
the AD curve thus affecting output,
unemployment, and inflation.
• A plot of the Phillips curve shows
the short-run tradeoff between
inflation and unemployment.
π
u
β
1
un
πe
+v
A policymaker who controls AD can choose
a combination of inflation and unemployment
on this short-run Phillips curve.

10. The Short Run Tradeoff Between Inflation and
Unemployment
π
u
β
1
un
πe
+v
An increase in expected inflation
causes the curve to shift upward.
So that at any unemployment rate
there will be higher inflation.
• Because people adjust their
expectations of inflation over
time, the tradeoff between
inflation and unemployment
holds only in the short run.
• In the long run, expectations
adapt, inflation returns to
whatever rate the policymaker
has chosen, and unemployment
returns to the natural rate.

11. Conclusions
• In this section we discussed the Phillips curve. The
Phillips curve demonstrates the inflation-
unemployment tradeoff that policy makers face.