1. The Phillips Curve
The AD-AS model shows the relationship between the price level and output. The Phillips Curve shows the same relationship from a different angle β the trade-off between inflation and unemployment. Think of it as the AD-AS model's twin.
The Short-Run Phillips Curve (SRPC)
Short-Run Phillips Curve (SRPC): Shows an inverse (trade-off) relationship between the inflation rate and the unemployment rate in the short run. When unemployment falls, inflation rises β and vice versa.
- Point A: Long-run equilibrium β at the NRU, on the LRPC, with stable inflation (Οβ).
- Point B: AD increases β unemployment falls below NRU, but inflation rises. Movement along SRPCβ (short-run trade-off).
- Point C: Workers expect higher inflation β demand higher wages β SRPC shifts up/right to SRPCβ. Economy returns to NRU but at higher inflation.
The Long-Run Phillips Curve (LRPC)
LRPC: A vertical line at the Natural Rate of Unemployment (NRU). In the long run, there is no trade-off between inflation and unemployment. The economy returns to the NRU regardless of the inflation rate.
π― The AD-AS β Phillips Curve Connection:
β’ AD-AS: LRAS is vertical at Yf (full employment output)
β’ Phillips Curve: LRPC is vertical at the NRU
β’ These are the same idea on different graphs! LRAS shows output can't permanently exceed potential; LRPC shows unemployment can't permanently stay below natural rate.
What Shifts the Phillips Curves?
| Curve | Shifts Right | Shifts Left |
|---|---|---|
| SRPC |
β Expected inflation (workers demand higher wages) Negative supply shock (β oil prices) |
β Expected inflation Positive supply shock (β oil prices) |
| LRPC | β NRU: more structural/frictional unemployment (β labor skills, more regulations, demographic shifts) | β NRU: improved job matching, better training, reduced barriers to employment |
Stagflation on the Phillips Curve
Remember stagflation (β inflation + β unemployment simultaneously)? On the AD-AS model, it's a leftward shift of SRAS. On the Phillips Curve, it's a rightward/upward shift of the SRPC β both inflation and unemployment increase at the same time. This breaks the short-run trade-off temporarily.
2. Fiscal & Monetary Policy in the Long Run
In Units 3 and 4 you learned how fiscal and monetary policy shift AD in the short run. Now comes the critical question: what happens in the long run?
The Long-Run Neutrality of Money
In the long run, changes in the money supply only affect the price level β not real output or employment. This is called the neutrality of money. More money in the economy doesn't create more goods; it just makes each dollar worth less (inflation).
Here's the step-by-step long-run story for expansionary monetary policy:
Step 1 (Short Run): Fed β MS β β interest rate β β I β AD shifts right β β Real GDP above Yf, β Unemployment below NRU, β Price Level
Step 2 (Adjustment): Low unemployment β workers demand higher wages β β production costs β SRAS shifts left
Step 3 (Long Run): Economy returns to Yf at a higher price level. Real GDP is unchanged. Only prices went up.
The same logic applies in reverse for expansionary fiscal policy:
Short Run: β G or β T β AD shifts right β β Y, β Unemployment, β PL
Long Run: Wages adjust upward β SRAS shifts left β Y returns to Yf at a higher price level.
The Long-Run Bottom Line
Demand-side policies (fiscal & monetary) can change output in the short run,
but in the long run they only change the PRICE LEVEL.
Only supply-side changes (β technology, β capital, β labor) can permanently increase real output.
On the Phillips Curve
The long-run story plays out identically:
| Step | AD-AS Model | Phillips Curve |
|---|---|---|
| Short Run (ADβ) | Y > Yf, PL rises | Move up-left along SRPC: β unemployment, β inflation |
| Adjustment | SRAS shifts left as wages rise | SRPC shifts right as expected inflation rises |
| Long Run | Y = Yf, higher PL | Back on LRPC at NRU, but at higher inflation rate |
3. Government Deficits & the National Debt
When the government uses expansionary fiscal policy (β G or β T), it often spends more than it collects. This creates a deficit. Understanding the difference between deficits and debt β and their consequences β is essential for the AP exam.
Deficit vs. Debt
Budget Deficit (Flow)
Definition: Government spending exceeds tax revenue in a single year.
Think of it as the annual shortfall β like spending $5,000/month when you earn $4,000.
National Debt (Stock)
Definition: The total accumulation of all past deficits minus any surpluses. It's what the government owes in total.
Think of it as total credit card balance β the sum of all the months you overspent.
π§ Easy Memory: Deficit = this year's gap (flow). Debt = the running total of all gaps (stock). A deficit adds to the debt each year. A surplus reduces the debt.
How the Government Finances a Deficit
When the government spends more than it collects, it must borrow. It does this by selling Treasury bonds to investors (domestic and foreign). This has several consequences:
| Consequence | Explanation |
|---|---|
| β Demand for Loanable Funds | Government enters the borrowing market β DLF shifts right β real interest rates rise. |
| β Private Investment | Higher interest rates make borrowing more expensive for businesses β crowding out (see Section 4). |
| Interest Payments on Debt | The government must pay interest to bondholders. As debt grows, interest payments consume a larger share of the budget, leaving less for other spending. |
| Foreign Ownership | When foreigners buy US bonds, interest payments flow out of the country. The US "owes" foreign holders, which can reduce national income over time. |
4. Crowding Out
You first met crowding out in Units 3 and 4. Now we go deep. Crowding out is the central reason why expansionary fiscal policy is less effective than the simple multiplier suggests β and it's one of the AP exam's favorite topics.
Crowding Out: When increased government borrowing drives up real interest rates, which reduces (or "crowds out") private investment spending. The fiscal stimulus is partially offset by the decline in private sector activity.
The Complete Crowding Out Chain
1. Government runs a budget deficit (β G or β T)
2. Government must borrow β sells Treasury bonds
3. DLF shifts right in the Loanable Funds Market
4. Real interest rate rises
5. Private Investment (I) falls (firms borrow less at higher rates)
6. The increase in AD from β G is partially offset by the decrease from β I
7. Net effect on GDP is smaller than the full multiplier would predict
Visualizing Crowding Out: Two Graphs
Loanable Funds Market
Gov't borrowing shifts DLF right β real interest rate rises from rβ to rβ.
AD-AS Model
AD shifts right, but less than the full multiplier predicts because β r β β I.
Degrees of Crowding Out
| Degree | What It Means |
|---|---|
| Partial Crowding Out | Most common scenario. β G is partially offset by β I. GDP still rises, but by less than the full multiplier effect. This is the standard AP exam answer. |
| Complete Crowding Out | β G is entirely offset by β I. No net change in GDP. This is a theoretical extreme β the increase in government spending exactly equals the decrease in private investment. |
| No Crowding Out | Occurs when the economy has significant slack (deep recession) and interest rates are already near zero. Additional government borrowing doesn't significantly raise rates. The full multiplier operates. |
π― Fiscal vs. Monetary β Crowding Out Comparison:
Fiscal policy β causes crowding out (gov't borrowing β real interest rates β β I).
Monetary policy β does NOT cause crowding out. In fact, expansionary monetary policy β interest rates, which increases I. This is why many economists argue monetary policy is more effective at stimulating the economy.
5. Economic Growth
Everything we've studied in Units 3β4 is about the short run β managing the business cycle. But the most important question in economics is the long run one: How do we make the economy bigger over time?
Economic Growth: A sustained increase in real GDP per capita over time. On our models, this is shown as an outward shift of the PPC or a rightward shift of LRAS.
Sources of Economic Growth
Growth comes from increasing the quantity or quality of resources, or from using them more efficiently:
| Source | How It Creates Growth |
|---|---|
| Physical Capital | More machines, factories, infrastructure β workers produce more per hour. Investment (I) in capital goods is the key driver. |
| Human Capital | Education, training, healthcare β workers become more skilled and productive. A more educated labor force produces more output per person. |
| Technology / Innovation | New inventions, better processes β more output from the same inputs. Technology is the most powerful long-run growth engine. |
| Natural Resources | Discovery of new resources or better ways to extract existing ones. |
| Labor Force Growth | β Population, immigration, or β labor force participation β more workers producing goods. |
| Institutional Factors | Property rights, rule of law, stable government, free trade, efficient financial markets β create incentives for investment and innovation. |
Productivity: The Key to Growth
Productivity Formula
Productivity is the single most important determinant of a country's standard of living. Countries with high productivity have high real GDP per capita.
Supply-Side (Long-Run) Policies
Unlike demand-side policies (fiscal/monetary) that shift AD, supply-side policies aim to shift LRAS right β actually increasing the economy's productive capacity:
| Policy | How It Promotes Growth |
|---|---|
| Investment in Education | β Human capital β β productivity β LRAS shifts right |
| Investment in Infrastructure | Better roads, ports, broadband β β costs for businesses β β productivity |
| R&D Spending / Tax Credits | Encourages technological innovation β β productivity |
| Lower Business Taxes | β After-tax profits β β incentive to invest in capital β β capital stock |
| Deregulation | Reduce compliance costs β resources redirected to production |
| Free Trade | Specialization via comparative advantage β β efficiency of resource use |
Growth on the Models
PPC Shifts Outward
More resources or better technology β can produce more of both goods.
LRAS Shifts Right
Potential GDP increases β full employment output rises.
LRPC Shifts Left
β NRU (better job matching, education) β LRPC shifts left.
The Capital Goods Trade-Off
Countries face a critical choice on the PPC: produce more consumer goods today (current living standards) or more capital goods (future growth). Countries that invest heavily in capital goods now β sacrificing current consumption β will see their PPC shift out faster in the future.
π― AP Exam Connection: This is why China (heavy capital investment for decades) had faster growth than many countries that consumed more. The AP exam loves the "capital goods vs. consumer goods" PPC question β the country that allocates more to capital goods will have a larger outward PPC shift in the future.
Unit 5 Key Takeaways
SRPC: Short-run trade-off between inflation & unemployment
LRPC: No long-run trade-off β vertical at NRU
Demand-side policies β change PL in long run, NOT real output
Deficits β borrowing β β real interest rate β crowding out
Only supply-side factors shift LRAS and create true growth
Productivity = (Real GDP / Hours Worked) | Growth = β LRAS = β PPC = β NRU
End of Unit 5 Study Guide.