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Video transcript

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 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 6% 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 6% 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 gonna 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 EP a-- dats 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 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 to our price level - and our new equilibrium output for economy sub - 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 and shifts an aggregate 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 2 so we went from a situation where before we had 6% unemployment and let's say we had 3% inflation to a world where maybe now we have I don't know let's call it 9% unemployment and now we have 2% 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 3 and so here our equilibrium price level is higher let's call it P sub 3 and our equilibrium output we have a positive output gap so Y sub 3 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 4% and now our inflation and this might be let's call that 4% 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 higher price level at this level of output people might want to have a higher level price 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 3 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 at a given 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 curves you could say shifts up or to the right so we would then have a short run Phillips curve Phillips curve that looks like this I'll call that sub 3 and we might get back to this point well for sure if we are at this full employment output then we are operating our natural rate of unemployment again but notice now our inflation has crept even higher this might be 5% 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 talked about long-run aggregate supply and 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 our 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 and 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
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