Learn the toughest concepts covered in your Macroeconomics class with step-by-step video tutorials and practice problems.

Revisiting Inflation, Unemployment, and Policy

Short Run Phillips Curve


Deriving the Short Run Phillips Curve; Unemployment and Inflation

Play a video:
Was this helpful?
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 gonna 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 while unemployment is gonna go up and vice versa. If we try and keep unemployment low inflation is gonna go up. So we'll see how that works. Um But on a high level when we think about our aggregate demand A. D. A. S. 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 G. D. P. And to create that GDP we need more workers. Um 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 um 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 uh 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 A. D. A. S. Model and then we're gonna draw our short run phillips curve here. Okay. So assume it's the first, assume year one 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 see what happens in the next year, we're gonna see how the short run phillips curve can be derived. Okay so we're gonna be analyzing situations for year two. Okay. So there could be two situations, let's say in year two there could be low aggregate demand or high aggregate demand. Okay, so that's what I've got here on the graph, there's two possibilities for aggregate demand and we're gonna 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 gonna 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 gonna have our GDP on this X. Axis which is where we're gonna 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. Okay so let's say we're at this low lower aggregate demand and we see that the price level in year two is 102. Right? So it was 100 in the first year and 102 in the second year. So this means there was approximately 2%. Well not approximately there was 2% inflation right from year one to year two. We saw 2% inflation there. Now let's say um we're in this higher situation, we're in the 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 G. D. P. Down there. We'll get to those in a second. But in this case let's say we have 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 second year. So this was year one right here we assumed was 100 the base here and now we're looking at year to what could happen. So it would be 106 in this situation. Okay so you can 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 drive 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 15,000 $15,000 worth of G. D. P. Of course that's a small number for a huge country. But let's keep the number simple. So 15,000 of G. D. P. There and at the higher aggregate demand, our equilibrium is say 16,000 G. D. P. So which of these GDP levels do you think we have uh 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 you E for unemployment, let's say unemployment in this situation, I will say is 4%, we're just making up a number there. And unemployment in this situation. Well if there's um there's less GDP less stuff being created, they need less workers to create it will say is 7% in this situation when we have 15,000 G. D. P. Alright so now let's go over to this graph on the right let me get out of the way and we're gonna do our short run phillips curve. So what we're seeing here is we're gonna have inflation the inflation rate on the y axis and the unemployment rate on the X. Axis. And what we're gonna do is we're gonna graph these two situations over here. Okay 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% right 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 G. D. P. Meaning less 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 gonna 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, our unemployment rate and inflation rate usually we're dealing with some sort of price and quantity on the axis 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 inflate 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 it's difficult to control both inflation and unemployment at the same time. Alright, so that's our 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 um analyses out of this curve as well. So, what what did we see happening this is the key thing to remember about this phillips curve is that as inflation increases unemployment decreases and as inflation decreases unemployment increases. Okay, the inverse relationship. I'm gonna write it here one more time in verse relationship. All right, So, that's our short run phillips curve. Let's go ahead and move on to the next video.