Economics - Phillips Curve

Inflation and Unemployment: Relationship

inverse relationship between inflation and unemployment in the short run

• Low unemployment → Firms raise wages to attract workers → Higher production costs → Inflation ↑

• High unemployment → Weak wage growth → Lower production costs → Inflation ↓

Low Unemployment: High Inflation

• Low unemployment → Firms raise wages to attract workers → Higher production costs → Inflation ↑

Low Unemployment: GDP Impact

Low unemployment: Boosts C (consumption) and I (investment) → AD shifts rightward → GDP ↑ (short-term)

High Unemployment: Low Inflation

• High unemployment → Weak wage growth → Lower production costs → Inflation ↓

High Inflation: GDP Impact

High inflation: Reduces purchasing power → Real GDP growth slows (long-term)

Short-Run Phillips Curve (SRPC): Definition

• Definition: Illustrates the inverse relationship between inflation and unemployment in the short term.

  • Example (Supporting SRPC): 1960s U.S. Economy: Low unemployment (~4%) coincided with rising inflation (~3%). Expansionary policies (e.g., tax cuts) boosted AD, lowering unemployment but increasing inflation.

Short-Run Phillips Curve (SRPC): GDP Impact

• AD ↑ (e.g., via fiscal stimulus) → Unemployment ↓ → Wages ↑ → Inflation ↑ (movement along SRPC)

• AS ↓ (e.g., oil price shock) → Stagflation (Inflation ↑ + Unemployment ↑), breaking the SRPC

Long-Run Phillips Curve (LRPC): Definition

• Definition: Vertical curve at the natural rate of unemployment, showing no tradeoff between inflation and unemployment in the long run

• Rationale: Workers and firms adjust expectations. Persistent inflation becomes anticipated, neutralizing employment effects

Long-Run Phillips Curve (LRPC): GDP Impact

Long-term GDP growth depends on productivity and AS shifts (e.g., technology, education)

Phillips Curve Short and Long-Run: GDP Impact

1. Short-Run:

• AD ↑ (e.g., expansionary policy) → Lower unemployment + Higher inflation (movement along SRPC)

• AS ↓ (e.g., supply shock) → Higher inflation + Higher unemployment (stagflation; SRPC shifts right)

1. Long-Run:

• LRPC vertical: No tradeoff. Inflation-targeting policies focus on stabilizing expectations

Stagflation: Criticism of Phillips Curve

• Stagflation: High inflation + High unemployment (e.g., 1970s oil crises).

  • Example: 1970s U.S.: Oil embargoes caused AS ↓ (higher production costs) → Inflation hit 13% while unemployment rose to 9%.

• Modern Challenges: 2010s U.S.: Low inflation (~2%) and low unemployment (~4%) coexisted, contradicting SRPC predictions.

Stagflation: Definition

• Stagflation: High inflation + High unemployment (e.g., 1970s oil crises)

  • Example (1970s US): Oil embargoes caused AS ↓ (higher production costs) → Inflation hit 13% while unemployment rose to 9%

Phillip’s Curve: Key Takeaways! 🦊

• SRPC explains short-term tradeoffs but fails during supply shocks or when expectations adjust.

• LRPC emphasizes structural factors (e.g., technology, education) for long-term GDP growth.

• Policy implications:

  • Short-term: Use AD policies cautiously to avoid inflationary spirals.

  • Long-term: Invest in AS-boosting measures (e.g., R&D, workforce training).