Changes in the AD-AS Model and the Phillips curve | APⓇ Macroeconomics | Khan Academy

In this video, we're going to build on what we already know about aggregate demand and aggregate supply and the Phillips curve, and we're going to connect these ideas.

So first, the Phillips curve. This is a typical Phillips curve for an economy. High inflation is associated with low unemployment; high unemployment is associated with low inflation. But we can really view this curve as the short-run Phillips curve. We might sit at different points on this curve at different points in an economic cycle. But we can also introduce an idea known as a long-run Phillips curve, which is just based on the natural rate of unemployment for this economy.

So let's say the natural rate of unemployment for this economy is six percent. So then our long-run Phillips curve would just be a vertical line right over there. Long-run Phillips curve. Now, why is it a vertical line? Well, it says in the long run, our natural rate of unemployment is six percent, regardless of what the inflation rate might be.

And so, if we are sitting at the intersection of these two curves, that means that our economy right in this moment in time is operating at full employment. If unemployment was lower than that, it would be overheating to some degree, and if unemployment were higher than that, then we would have a negative output gap.

But how do we tie these ideas to aggregate demand and aggregate supply? Well, let's draw our long-run aggregate supply curve, and I'm going to do it right at the intersection of our aggregate demand and short-run aggregate supply curve for now because I want to show an economy that's operating at its full potential.

So here, this is our long-run aggregate supply, and once again it's a vertical line because in the long run, regardless of the price level, we have a certain output for this economy that is sustainable. So that is our full employment. I'll do F period E period; that's our full employment output. Anything more than that, it's unsustainable based on where the economy is structurally right now, and anything less than that is you have a negative output gap.

But now, let's think about what would happen if we start shifting curves around. What if we were to have a negative demand shock? So our aggregate demand curve shifts to the left. Well, in that world—and this is all a review—you can see that your equilibrium price, so let me call this aggregate demand sub two, our price level two, and our new equilibrium output for our economy, sub two. You can see that both are lower; we now have a negative output gap.

But what would that correspond to here on our Phillips curves? Well, when you have a negative output gap, you're likely to have higher unemployment. Shifts in the aggregate demand curve would be movements along the short-run Phillips curve. So we're going to move along the short-run Phillips curve, and we're going to have higher unemployment because we have a negative output gap. So we might get to that point right over there, so I'll just call that point sub two.

So we went from a situation where before we had six percent unemployment, and let's say we had three percent inflation, to a world where maybe now we have, I don't know, let's call it nine percent unemployment, and now we have two percent inflation. And it could go the other way around. Let's say we were starting from our original aggregate demand curve and you have a positive demand shock, and so now we could get to this curve aggregate demand three.

And so here, our equilibrium price level is higher; let's call it P sub three, and our equilibrium output—we have a positive output gap, so Y sub three. And that would correspond to, if we have a positive output gap, that means we have very low unemployment, maybe unsustainably low unemployment. So we might be right over here, so this might be a situation where our unemployment rate, let's say that's about, I don't know, four percent, and now our inflation—this might be, let's call that four percent as well.

And something interesting happens; as you start to have higher and higher inflation, that can lead to people just having higher expectations for price and higher expectations for inflation itself. And if folks have higher expectations for inflation, well then they might want to charge more for a certain level of output. So let's say this level of output, people might want to have a higher price level; at this level of output, people might want to have a higher price level.

And so it could actually shift our short-run aggregate supply up, or you could say to the left. So short-run aggregate supply, I'll call that sub three. Now, when the short-run aggregate supply gets shifted to the left in this situation, notice we are back to our full employment output, but our price level is now much higher.

Now, what would that correspond to over here? Well, when you have a shift in short-run aggregate supply curves, that would actually lead to a shift in your short-run Phillips curve. But which way would it shift? Well, another way to think about it is, just as at a given level of output you would have expected higher price because of this increased inflation expectations, so here at a given level of unemployment, you would expect a higher level of inflation.

So our curve, you could say, shifts up or to the right. So we would then have a short-run Phillips curve that looks like this; I'll call that sub three, and we might get back to this point. Well, for sure, if we're at this full employment output, then we are operating at our natural rate of unemployment again. But notice now our inflation has crept even higher; this might be five percent inflation.

Now, the last thing you might be wondering about is when do these long-run curves ever shift? Well, we've talked about it before. When we talk about long-run aggregate supply, that shifts if the economy structurally changes somehow. Let's say our factories get bombed out in a war or something; then this should shift to the left.

And if we got better technology or better ways of organizing ourselves, or more resources, this might shift to the right. Similarly, if there's a massive shift in global trade and maybe our worker skills aren't as valuable anymore in the global economy, then this long-run Phillips curve might shift to the right.

If all of a sudden we are able to—or over time—we're able to get people more skilled, maybe we get frictional unemployment down because we have better technology to place people, well that might shift this to the left.