Where is the Friedman Curve?

We have only answered half of the question. In a sense, we have located the Potential Output line, but where on the PO line will we find the Friedman Curve?

The New Classical interpretation will help us here. If prices have been stable (zero inflation) for a long time, and conditions are unchanged, then people will expect the price level to be the same as it was last year. If prices have been changing, then people will have some opinion as to the most likely rate of inflation (or deflation) and will expect the price level to be at last year's level plus the expected rate of inflation (or minus the expected rate of deflation). Either way, people will have an "expected price level" for the coming year.

This is crucial for the FC. Remember, the FC is upward-sloping because people can be taken by surprise: if the actual price level is above the expected price level, then production will be greater than otherwise, and if the actual price level is below the expected price level, production will be less than otherwise. On the other hand, the LAS by definition is the no-surprise real GDP. Therefore, FC and PO must be the same when people are not surprised by the price level. That is, the FC and PO coincide when the actual price level is equal to the expected price level.

We now have the information to locate the aggregate supply curves in two steps:

  1. The Long Run Aggregate Supply Curve is the Potential Output curve, a vertical line at the real GDP that corresponds to the NAIRU.
  2. The Short Run Aggregate Supply Curve is the Friedman Curve, an upward-sloping curve that crosses the PO at the expected price level.
Here is a diagram that illustrates this:

Figure 5: The Long and Short Run Aggregate Supply


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