13 Phillips Curve & Supply-side Policies

Lecture from: 09.12.2025 | Video: Video ETHZ

Introduction: The Twin Goals

The AD-AS framework is now translated into the two variables that dominate the political landscape: inflation and unemployment.

• Goal: Low inflation AND Low unemployment.
• Problem: In the short run, these goals often conflict.

This lecture explores the trade-off known as the Phillips Curve and concludes with policies designed to improve the supply side of the economy.

---

The Short-Run Phillips Curve (SRPC)

Empirically observed in the 1960s (using UK/US data), the Phillips Curve shows a stable inverse relationship between unemployment and inflation.

The Logic: AD-AS Translation

The Phillips Curve is simply the aggregate supply curve looked at from a different angle.

1. High Aggregate Demand:
   • AD-AS View: Variable Output ($Y$) is high; Price Level ($P$) is high.
   • Phillips View: Unemployment ($u$) is low; Inflation ($\pi$) is high.
2. Low Aggregate Demand:
   • AD-AS View: Variable Output ($Y$) is low; Price Level ($P$) is low.
   • Phillips View: Unemployment ($u$) is high; Inflation ($\pi$) is low.

Okun's Law Connection

The link between Output ($Y$) and Unemployment ($u$) is given by Okun’s Law. High output requires more workers, lowering unemployment.

---

The Long-Run Phillips Curve (LRPC)

In the late 1960s, Friedman and Phelps challenged the idea of a permanent trade-off. They argued that because monetary neutrality holds in the long run, nominal variables (inflation) cannot affect real variables (unemployment).

• Result: The Long-Run Phillips Curve is vertical.
• Location: Fixed at the Natural Rate of Unemployment.

implication: Policymakers cannot permanently lower unemployment by generating high inflation. They can only achieve it temporarily.

---

Reconciling Short and Long Run: Expectations

Why does the trade-off exist in the short run but vanish in the long run? The key variable is Expected Inflation ($P^e$).

The Modern Equation:

$$\text{Unemployment}=\text{Natural Rate}-a(\text{Actual }\pi -\text{Expected }\pi )$$

The Mechanism of Breakdown (1970s)

1. Start (Point A): Economy is at the natural rate. Inflation is low and expected to be low.
2. Expansion (Point B): Govt boosts money supply to lower unemployment. Actual inflation > Expected inflation. Real wages fall, hiring rises. Unemployment falls. Movement along the SRPC.
3. Adaptation: People realize prices are rising. They revise expectations upward ($P^e\uparrow$).
4. Shift (Point C): Higher expected inflation shifts the SRPC to the Right. Firms/workers demand higher nominal wages to offset expected prices.
5. Result: Unemployment returns to the natural rate, but inflation remains permanently higher.

The Lesson

You can fool some of the people some of the time (Short Run), but you can’t fool all of the people all of the time (Long Run). Attempting to keep unemployment below the natural rate results in accelerating inflation.

---

Supply Shocks and Cost-Push Inflation

The Phillips Curve analysis assumes demand shocks. Supply shocks (like the 1970s oil crisis) change the game.

• Adverse Supply Shock: SRAS shifts left.
• Phillips Effect: SRPC shifts Right.
• Result: Stagflation. Higher inflation AND Higher unemployment at every point. The trade-off worsens.

The Cost of Disinflation

To reduce high inflation, the central bank must contract the economy.

1. Contraction: AD falls. Economy moves down the SRPC (High unemployment, falling inflaiton).
2. Sacrifice Ratio: The % of one year’s GDP that must be lost to reduce inflation by 1%. (Typical estimate: 5).
3. Adjustment: Eventually, expectations fall, SRPC shifts left, and the economy returns to the natural rate with low inflation.

Rational Expectations & Credibility

If people believe the central bank is committed to fighting inflation, they may lower expectations immediately. This “credible commitment” can reduce the sacrifice ratio, making disinflation less painful. This is the argument for Central Bank Independence.

---

Supply-Side Policies

If demand management only offers short-term gains or painful trade-offs, how can the economy improve permanently? By shifting the Long-Run Aggregate Supply (LRAS) to the right.

Goal: Increase potential output ($\hat{Y}$) and lower the natural rate of unemployment.

1. Market-Oriented Policies

Philosophy: Remove government distortions to improve efficiency.

• Tax Reform (Laffer Curve): Lowering high marginal tax rates may encourage more work and investment, potentially increasing total tax revenue.
• Labor Market Deregulation: Reducing employment protection or minimum wages to lower the natural rate of unemployment.
• Privatization: selling state-owned enterprises to increase efficiency.

2. Interventionist Policies

Philosophy: Government must invest where markets fail.

• Infrastructure: Building better transport/digital networks implies lower costs for all firms.
• Education: Investing in Human Capital ($H$).
• R&D: Subsidizing research to boost Technological Knowledge ($A$).

Policy Synthesis

• Demand-Side (Fiscal/Monetary): Best for smoothing short-run shocks (stabilization).
• Supply-Side: Best for long-run growth and structural improvements.

---

Continue here: 14 Course Overview