ECON102: Principles of Macroeconomics (2021.A.01)

Comparing the very late 1990s to the early 2000s, Figure 16.4 "Connecting the Points: Inflation and Unemployment" shows that both periods exhibit Phillips phases, but that the early 2000s has both higher inflation and higher unemployment. One way to explain these back-to-back Phillips phases is to look at Figure 16.6 "A Phillips Phase". Assume point 1 represents the economy in 2001, with aggregate demand increasing. At the same time, though, oil and other commodity prices were rising markedly ­– tripling between 2001 and 2007. Thus, the short-run aggregate supply curve was also shifting to the left of SRAS_1,2,3. This would mean that output would be somewhat lower, unemployment somewhat higher, and inflation somewhat higher than what is shown as points 2 and 3 in Panels (a) and (b) of  Figure 16.6 "A Phillips Phase". The 2000s Phillips curve would thus be above the late 1990s Phillips curve. While the Phillips phase of the early 2000s is farther from the origin than that of the late 1990s, it is noteworthy that the economy did not go through a severe stagflation phase, suggesting some learning about how to conduct monetary and fiscal policy.

The recession that began in late 2007 is largely seen as a shift to the left in aggregate demand due to the marked fall in housing prices and financial market stresses. As a result, the economy went through a Phillips phase of higher unemployment and lower inflation. The expansionary monetary and fiscal policies of the late 2000s were geared toward pushing the aggregate demand curve back toward the right, thereby cajoling the economy back up the negatively sloped short-run Phillips curve.

We can conclude that policy efforts to change aggregate demand, together with changes in expectations and a wide variety of factors that cause the aggregate demand or aggregate supply curve to shift, have played an important role in generating the inflation-unemployment patterns we observe in the past half century.

Lags have played a crucial role in the cycle as well. If policy makers respond to a recessionary gap with an expansionary fiscal or monetary policy, then we know that aggregate demand will increase, but with a lag. Policy makers could thus undertake an expansionary policy and see little or no response at first. They might respond by making further expansionary efforts. When the first efforts finally shift aggregate demand, subsequent expansionary efforts can shift it too far, pushing real GDP beyond potential and creating an inflationary gap. These increases in aggregate demand create a Phillips phase. The economy’s correction of the gap creates a stagflation phase. If policy makers respond to the stagflation phase with a new round of expansionary policies, the initial result will be a recovery phase. Sufficiently large increases in aggregate demand can then push the economy into another Phillips phase, and so on.