# Lesson summary: the Phillips curve

## Lesson Summary

Helen of Troy may have had “the face that launched a thousand ships,” but Bill Phillips had the curve that launched a thousand macroeconomic debates. Bill Phillips observed that unemployment and inflation appear to be inversely related. The original Phillips curve demonstrated that when the unemployment rate increases, the rate of inflation goes down.
Since Bill Phillips’ original observation, the Phillips curve model has been modified to include both a short-run Phillips curve (which, like the original Phillips curve, shows the inverse relationship between inflation and unemployment) and the long-run Phillips curve (which shows that in the long-run there is no relationship between inflation and unemployment).
Any change in the AD-AS model will have a corresponding change in the Phillips curve model. We can also use the Phillips curve model to understand the self-correction mechanism. Perhaps most importantly, the Phillips curve helps us understand the dilemmas that governments face when thinking about unemployment and inflation.

## Key terms

Key termDefinition
Phillips curve modela graphical model showing the relationship between unemployment and inflation using the short-run Phillips curve and the long-run Phillips curve
short-run Phillips curve (“SPRC)a curve illustrating the inverse short-run relationship between the unemployment rate and the inflation rate
long-run Phillips curve (“LRPC”)a curve illustrating that there is no relationship between the unemployment rate and inflation in the long-run; the LRPC is vertical at the natural rate of unemployment.

## Key Model: the Phillips curve model

There are two schedules (in other words, "curves") in the Phillips curve model:
1. The short-run Phillips curve ($SRPC$). Every point on an $SRPC$ represents a combination of unemployment and inflation that an economy might experience given current expectations about inflation. For example, an economy that is on point 1 in Figure 1 above currently has an unemployment rate of $5\%$ and an inflation rate of $2\%$. At point 2, the unemployment rate decreases to 3% and the rate of inflation increases to $7\%$, moving along the $SRPC$ to the left. Movements along an SRPC, such as a movement from point 1 to point 2, indicate aggregate demand ($AD$) has changed. Shifts of the $SRPC$, such as a movement from point 2 to point 3, indicate a change in short-run aggregate supply ($SRAS$).
2. The long-run Phillips curve ($LRPC$). The $LRPC$ is vertical at the natural rate of unemployment. Figure 1 tells us that this economy’s natural rate of unemployment is $5\%$.

## Key Takeaways

### The economy is always operating somewhere along a short-run Phillips curve

Like the production possibilities curve and the AD-AS model, the short-run Phillips curve can be used to represent the state of an economy.
The table below summarizes how different stages in the business cycle can be represented as different points along the short-run Phillips curve.
How this appears in a PPCHow this appears in an AD-AS modelHow this appears in the Phillips curve model
A recession (UR>URn, low inflation, Y<Yf)
An inflationary gap (UR<URn, high inflation, Y>Yf)
Long run equilibrium (UR=URn, Y=Yf)

### Aggregate demand ($AD$) shocks and the Phillips curve

Assume an economy is initially in long-run equilibrium (as indicated by point $A$ in the two graphs shown in the table below), but then it experiences an $AD$ shock. How might that shock result in an increase or decrease in $AD$, and how can we use the Phillips curve model to illustrate that?
The two graphs below show how that impact is illustrated using the Phillips curve model.
How an increase in $AD$ (a positive $AD$ shock) appears in the Phillips modelHow a decrease in $AD$ (a negative $AD$ shock) appears in the Phillips model
A movement from point A to point B represents an increase in AD. When AD increases, inflation increases and the unemployment rate decreases.A movement from point A to point C represents a decrease in AD. When AD decreases, inflation decreases and the unemployment rate increases.

### SRAS and the Phillips curve (PC)

Previously, we learned that an economy adjusts to aggregate demand ($AD$) shocks in the long run. For example, when $AD$ increases the price level also increases. Eventually, the increase in the price level will lead to higher wages, which will cause short-run aggregate supply ($SRAS$) to decrease.
That long-run adjustment mechanism can be illustrated using the Phillips curve model also. When $SRAS$ shifts, the $SRPC$ shifts in the opposite direction, as summarized in the table below:
How a decrease in SRAS (shift left) appears in the PC modelHow an increase in SRAS (shift right) appears in the PC model
An economy is initially in long-run equilibrium at point $X$, but an increase in aggregate demand decreases unemployment and increases inflation, resulting in the move to point $Y$. When people expect there to be $7\%$ inflation permanently, $SRAS$ will decrease (shift left) and the $SRPC$ shifts to the right.An economy is initially in long-run equilibrium at point $X$, but a decrease in aggregate demand increases unemployment and decreases inflation, resulting in the move to point $Y$. When people expect there to be $3\%$ inflation permanently, $SRAS$ will increase (shift right) and the $SRPC$ shifts to the left.
The shift in SRPC represents a change in expectations about inflation. For example, suppose an economy is in long-run equilibrium with an unemployment rate of 4% and an inflation rate of 2%. If there is a shock that increases the rate of inflation, and that increase is persistant, then people will just expect that inflation will never be 2% again.
That means even if the economy returns to 4% unemployment, the inflation rate will be higher. There is no way to be on the same SRPC and experience 4% unemployment and 7% inflation. Therefore, the SRPC must have shifted to build in this expectation of higher inflation.

### The natural rate of unemployment and the long-run Phillips curve

Anything that changes the natural rate of unemployment will shift the long-run Phillips curve. Recall that the natural rate of unemployment is made up of:
Frictional unemployment Structural unemployment
For example, if frictional unemployment decreases because job matching abilities improve, then the long-run Phillips curve will shift to the left (because the natural rate of unemployment decreases). Or, if there is an increase in structural unemployment because workers’ job skills become obsolete, then the long-run Phillips curve will shift to the right (because the natural rate of unemployment increases).

## Common misperceptions

• In many models we have seen before, the pertinent point in a graph is always where two curves intersect. So you might think that the economy is always operating at the intersection of the SRPC and LRPC. However, this assumption is not correct. Any point along the SRPC could be where an economy is operating. The only time the economy is at the point where the SRPC and LRPC intersect is when it is in long-run equilibrium.
• Sometimes new learners confuse when you move along an SRPC and when you shift an SRPC. Changes in cyclical unemployment are movements along an SRPC. Changes in the natural rate of unemployment shift the LRPC.
• Movements along the SRPC are associated with shifts in AD. Shifts of the SRPC are associated with shifts in SRAS.
• Changes in cyclical unemployment are movements along an SRPC. Changes in the natural rate of unemployment shift the LRPC.

## Questions for review

The economy of Wakanda has a natural rate of unemployment of 8%. Its current rate of unemployment is 6% and the inflation rate is 7%.
1. Show the current state of the economy in Wakanda using a correctly labeled graph of the Phillips curve using the information provided about inflation and unemployment.
2. What kind of shock in the AD-AS model would have moved Wakanda from a long run equilibrium to the country’s current state? Explain.
3. As a result of the current state of unemployment and inflation what will happen to each of the following in the long run?
a) The short-run Phillips curve (SRPC)? Explain.
b) The long-run Phillips curve (LRPC)? Explain.