Aggregate Supply, Phillips Curve and Three Faces of Aggregate Supply

Aggregate Supply and the Phillips Curve:


The Okun’s law which you will recall is the simple yet strong relationship among the unemployment rate and real GDP. Letting u symbolize the unemployment u* for the economy’s natural rate of unemployment at which there is neither upward nor downward pressure on inflation, Y symbolize real GDP, and Y* symbolize potential output, then Okun’s law is:

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For the reason of Okun's Law, we don’t have to separately keep track of what is happening to real GDP (relative to potential output) and to the unemployment rate. Utilizing Okun’s law, you are able to easily go back and forth from one to the other. It is typically more convenient to work with the unemployment than with the output gap—real GDP relative to potential output—if only for the reason that the unemployment rate is easier to measure.

We gazed at the aggregate supply relationship. We gazed at it in one way, as well as saw that when real GDP is greater than potential output the price level is likely to be higher than people had expected, thus aggregate supply related the price level (relative to the previously-expected price level) to the level of real GDP (relative to potential output):

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We looked at it a subsequent way, as well as saw aggregate supply as a relationship between the inflation rate (relative to the previously-expected inflation rate) and the level of real GDP (relative to potential output).

2401_level of real gdp.jpg

For the reason that inflation this year minus what inflation had been expected to be is the same as the proportional dissimilarity between the price level now and what the price level had been expected to be, these are both dissimilar ways of looking at the same economic process.

We are able to use Okun’s law to look at aggregate supply in yet a third way.

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For the reason that we can substitute the right-hand side of the equation above for (Y-Y*)/Y in our aggregate supply function:

- 2.5 x ( u - u*) = θ x (Π - Πe)
If we rearrange to place the inflation rate by itself on the left-hand side:

Π = Πe- (2.5/θ) x ( u - u*)

and then define the parameter β = 2.5/θ, the resulting function:

Π = Πe - β x ( u - u*)

is called as the Phillips curve, subsequent to the New Zealand economist A.W. Phillips, who initial wrote back in the 1950s of the relationship between unemployment and the rate of change of prices. Generally we will want to add an extra term to the Phillips curve:

Π = Πe - β x ( u - u*) + εs

where  εs   represents supply shocks—like the 1973 oil price raise—that can directly affect the rate of inflation.

The Phillips Curve:

2105_philips curve.jpg

Legend: When inflation is elevated than expected inflation and production is higher than potential output, the unemployment rate will be lesser than the natural rate of unemployment. There is an opposite relationship in the short run between inflation and unemployment.

From this point on, we will about always use the unemployment-inflation Phillips curve form. It is merely more convenient than the other forms.

Three Faces of Aggregate Supply:

1656_three phases of aggregate supply.jpg

Legend: You are able to think of aggregate supply either as a relationship between production (relative to potential output) and the price level, among production (relative to potential output) and the inflation rate, or between unemployment (relative to the natural rate of unemployment) and the inflation rate. These are three diverse views of what remains the same single relationship.

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