- [Tutor] Let's talk a little bit about
the short run and long run Phillips curve,
now they're named after the economist, Bill Phillips,
who saw in the 1950s
what looked like an inverse relationship
between inflation and the unemployment rate
and he was studying decades of datasets
in the United Kingdom,
where he saw usually when we had high,
or when the United Kingdom had high inflation,
you had relatively low unemployment
and that tended to be when the economy was doing well,
so he would see these data points
from the different years and then he would see
that when there was a high unemployment rate,
when the economy was a little bit slower,
then you had low inflation
and so he theorized the existence of a curve,
that could describe this relationship,
maybe it looks something like this
and if we take this model or if we assume this model,
then it would hold that when the economy is strong,
you have high inflation, low unemployment,
when the economy is weak,
you have high unemployment and low inflation.
Now you fast forward to the 1970s
and economists started to see a situation,
where this broke down, in the 1970s in particular,
you saw situations of stagflation,
where you had both high unemployment and high inflation,
so it didn't seem to fit the Phillips curve
and so economists theorized that,
okay, maybe this thing that Phillips theorized
is really just what happens in the short run,
so they said that this is the short run Phillips curve,
but they theorized that there's actually
a long run Phillips curve as well,
that describes the natural rate of unemployment
or the natural rate of unemployment you would get,
when the economy is at full employment
and remember, full employment doesn't mean
everyone's employed, it just means
a sustainable rate of employment for the country
and so if we wanted to draw that long run Phillips curve,
that economists theorized in the 1970s,
it might look something like this
and when you see it as a vertical line like this,
let me write this, long run Phillips curve,
it shows that over the long run,
the unemployment rate would be this value right over here
irrespective of what's going on with inflation
and so let's say for this economy,
our natural rate of unemployment is 4%
and we see that it is associated with 1% inflation
and so you can imagine,
if there's some perturbations to the economy,
maybe the economy gets a little bit overheated,
well then, you could get a little bit
higher inflation and lower unemployment
or if the economy slows down a little bit,
you could have higher unemployment and lower inflation,
but it should gravitate back to the long run Phillips curve.
But now let's think about this in context
of our aggregate demand, aggregate supply model
and think about a scenario,
where our short run Phillips curve could actually shift.
So here we have our typical axes,
when we're thinking about
aggregate demand and aggregate supply,
we have real GDP on our horizontal axis,
the price level on our vertical axis
and so our aggregate demand curve
might look something like this, it is downward sloping,
so let's call that our aggregate demand curve
and then our short run aggregate supply curve
might look something like this,
so as price levels go up in the short run,
people are willing to produce more,
so this is our short run aggregate supply
and remember, when we talked about
aggregate demand and aggregate supply,
we talked about a notion of our full employment output,
which is you could view
as a sustainable rate of output for an economy
and we can draw that as a vertical line,
so this right over here
would be our long run
aggregate supply
and where it intersects our real GDP axis,
this is our full employment output,
if you wanna put some numbers on it,
maybe this is equal too for a small economy,
maybe this is equal to 50 billion dollars.
So the way we've just described this,
we are at equilibrium right now,
we are at full employment output,
our economy's producing 50 billion dollars per year
and our full employment output
implies an unemployment rate of 4%,
where we have 1% inflation.
Now let's say that there's some type of a demand shock,
let's say all of a sudden,
the government wants to stimulate the economy
even beyond where it is here and so you have a,
and so they start spending all of this money
and so you have a shift in the aggregate demand curve,
so it would shift to the right,
so the aggregate demand curve
would now look something like this,
let's call that aggregate demand two,
well, what happens now?
And we've seen this in previous videos,
now you have, we go from this equilibrium point,
which was at this full employment output
and at this price level, let's call that price level one
and now we are at this equilibrium point,
people are demanding more, so suppliers say,
"Hey, if you want me to produce more,
"I'm gonna charge you some more for it too,"
so our price level has gone up,
we're at price level two
and we are producing above full employment output,
maybe this level right here is 60 billion,
well, how would that be reflected on our Phillips curves?
Well, in the short run,
our economy has gotten a little bit above potential,
so in the short run,
so we would sit on the short run Phillips curve
and our unemployment rate would go down,
but if we assume the Phillips curve,
the short run Phillips curve model,
that means our inflation would go up,
so this point right over here
might correspond maybe to this point right over there,
where when we get to that beyond full employment output,
let's say that this is 60 billion right over here,
well maybe our unemployment rate is 2%
and our inflation rate here is 3%,
now what happens next?
Well, we've talked about this
when we studied aggregate demand and aggregate supply,
workers, when it's time for them
to renegotiate their contracts will say,
"Hey, prices have gone up, I'm not going to work
"for the same amounts over the long run,"
and so you have a shift to the left
of the aggregate supply curve, at any given price level,
there's going to be less supply, less output
and so if this shifts to the left,
eventually the equilibrium point
will go back to where everything intersects
with the long run aggregate supply curve,
so the short run aggregate supply curve shifts over there
and then we would be back to our full employment output,
although our price level would have gone even higher,
price level three.
Now many economists would argue that when you have a shift
in the short run aggregate supply,
so this would be short run aggregate supply two,
that that also is associated with a shift
in our short run Phillips curve,
because of these price increases
and because workers are trying
to renegotiate their salaries upwards
and labor is the biggest factor in price levels,
you might have increased inflation expectations,
so then the given rate of inflation,
you might start having a higher unemployment
and so this short run Phillips curve
could shift to the right, so instead of this
just gravitating back to where it was before,
the whole curve could shift to the right
and we get to a situation that looks like this,
where our inflation is still at 3%,
but we are back to the long run
unemployment rate of this economy.