Lesson summary: the Phillips curve
|Phillips curve model||a 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
- The short-run Phillips curve (). Every point on an 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 and an inflation rate of . At point 2, the unemployment rate decreases to 3% and the rate of inflation increases to , moving along the to the left. Movements along an SRPC, such as a movement from point 1 to point 2, indicate aggregate demand () has changed. Shifts of the , such as a movement from point 2 to point 3, indicate a change in short-run aggregate supply ().
- The long-run Phillips curve (). The is vertical at the natural rate of unemployment. Figure 1 tells us that this economy’s natural rate of unemployment is .
The economy is always operating somewhere along a short-run Phillips curve
|How this appears in a PPC||How this appears in an AD-AS model||How 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 () shocks and the Phillips curve
|How an increase in (a positive shock) appears in the Phillips model||How a decrease in (a negative 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)
|How a decrease in SRAS (shift left) appears in the PC model||How an increase in SRAS (shift right) appears in the PC model|
|An economy is initially in long-run equilibrium at point , but an increase in aggregate demand decreases unemployment and increases inflation, resulting in the move to point . When people expect there to be inflation permanently, will decrease (shift left) and the shifts to the right.||An economy is initially in long-run equilibrium at point , but a decrease in aggregate demand increases unemployment and decreases inflation, resulting in the move to point . When people expect there to be inflation permanently, will increase (shift right) and the shifts to the left.|
The natural rate of unemployment and the long-run Phillips curve
- 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
- 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.
- 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.
- As a result of the current state of unemployment and inflation what will happen to each of the following in the long run?