Philips Curve

Short Run

1. What is the Phillips Curve?

• It shows an inverse relationship between:

  • Inflation and

  • Unemployment

• In the short run, when inflation goes up, unemployment tends to go down, and vice versa

2. Why This Happens:

• When Aggregate Demand (AD) increases:

  • Firms sell more goods

  • They need more workers

  • Unemployment falls

  • But prices rise → inflation increases

• Opposite happens if AD falls: less demand → fewer workers needed → unemployment rises → inflation falls

3. Shape of the Short-Run Phillips Curve:

• It’s downward sloping

• High inflation = low unemployment

• Low inflation = high unemployment

4. Movements Along the SRPC:

• Caused by changes in Aggregate Demand (AD)

  • AD up → move up along SRPC (lower unemployment, higher inflation)

  • AD down → move down along SRPC (higher unemployment, lower inflation)

5. Shifts of the SRPC:

• Caused by Supply Shocks (change in Aggregate Supply, not AD)

  • Example: Negative supply shock (like an oil crisis) → SRPC shifts right (higher unemployment and higher inflation = stagflation)

  • Positive supply shock → SRPC shifts left (lower unemployment and lower inflation)

6. Important Point:

• Trade-off between inflation and unemployment exists only in the short run

• In the long run, the Phillips Curve becomes vertical (no trade-off) — but that’s another lesson

Long Run

1. What is the Long-Run Phillips Curve?

• In the long run, the Phillips Curve becomes vertical

• This means there’s no trade-off between inflation and unemployment in the long run

• The economy always tends toward the natural rate of unemployment (also called non-accelerating inflation rate of unemployment or NAIRU)

2. Why is it Vertical?

• In the long run, expectations adjust:

  • If inflation increases, workers and firms expect higher prices and demand higher wages

  • This raises costs for firms, which can lead to higher prices (inflation), but does not change the natural rate of unemployment

  • The economy eventually returns to its natural unemployment rate, regardless of inflation

3. Natural Rate of Unemployment:

• The natural rate is the level of unemployment that occurs even when the economy is at full potential

• It’s determined by factors like frictional and structural unemployment, not by inflation

4. Shifts of the Long-Run Phillips Curve:

• The LRPC can shift over time:

  • Increased AD (demand) or negative supply shocks (like a big oil price shock) can push the economy temporarily off its natural rate, but in the long run, it returns to the natural rate

  • Policy changes that affect the natural rate (e.g., better job training or higher labor market participation) could shift the LRPC to the left (lower natural unemployment)

5. The Key Takeaway:

• In the long run, there’s no trade-off between inflation and unemployment. The only way to reduce unemployment below the natural rate is through unsustainable inflation (which will eventually lead to higher inflation expectations and return to the natural rate)

• The LRPC is vertical at the natural rate of unemployment