V. Pedagogy

1. Points of Clarification

i. The AS Curve and the Phillips Curve. The jump from the AS curve of Chapter 7 (in price levels) to the expectations-augmented Phillips curve of Chapter 8 (in inflation rates) may be difficult for some students. Chapter 7 itself required a big conceptual jump by analyzing wage-price dynamics. Chapter 8 may well seem to be something completely new. Time is required for this transition. It is useful to point out that the AS curve and the expectations-augmented Phillips curve essentially capture the same relationship, one in terms of the price level, the other in terms of inflation. A more subtle point is that the assumption that expected inflation equals lagged inflation is not equivalent to the assumption that the expected price level equals the lagged price level. The former assumption generates an equilibrium inflation rate (when embedded in the full medium-run model of Chapter 9); the latter generates an equilibrium price level.

ii. Graphical Presentation. The material in this chapter is presented algebraically. An alternative is to employ a graphical approach. Instructors could show the downward-sloping Phillips curve and explain that increases in expected inflation and oil prices both shift the Philllips curve to the right. Moreover, the natural rate of unemployment intersects the Phillips curve where actual inflation equals expected inflation. If unemployment is lower than the natural rate, so that inflation is higher than expected, expected inflation increases and the Phillips curve shifts right. For a given state of aggregate demand, inflation and the unemployment rate both increase as the economy moves back toward the natural rate of unemployment. If unemployment is higher than the natural rate, expected inflation falls, the Phillips curve shifts left, and inflation and the unemployment rate fall as the economy moves back to the natural rate. Note that an increase in oil prices also increases the natural rate.

The graphical presentation has some advantages. One is that is easy to show that an attempt by policymakers to maintain an unemployment rate below the natural rate will result in increasing inflation, since expected inflation will continue to increase, and the Phillips curve will continue to shift up. Another is that the econometric collapse of the Phillips curve is easy to illustrate. As the Phillips curve shifts over time, we collect data from different Phillips curves. The result is collection of points that do not illustrate a downward-sloping Phillips curve.

VI. Extensions

Instructors could introduce rational expectations by considering the consequences of π=π^e in equation (8.3). Under this assumption, the unemployment rate equals its natural rate. Chapter 9 effectively discusses rational expectations, although it does not use the term, in the context of the credibility of monetary policymakers.

VII. Observations

In the medium run, there is no inflation in the AD-AS model. By contrast, the Phillips curve introduced in this chapter implies a constant (not necessarily zero) rate of inflation when unemployment is at its natural rate. The reason for this difference will become clear in the next chapter. In the AD-AS model, monetary policy is conceived in terms of the level of the money stock. In the medium-run model introduced in Chapter 9, monetary policy is conceived in terms of the growth rate of the money supply.

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