In this lesson summary review and remind yourself of the key terms and graphs related to the Phillips curve. Topics include the short-run Phillips curve (SRPC), the long-run Phillips curve, and the relationship between the Phillips' curve model and the AD-AS model.
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.
|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
There are two schedules (in other words, "curves") in 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
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 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
Assume an economy is initially in long-run equilibrium (as indicated by point in the two graphs shown in the table below), but then it experiences an shock. How might that shock result in an increase or decrease in , 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 (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)
Previously, we learned that an economy adjusts to aggregate demand () shocks in the long run. For example, when 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 () to decrease.
That long-run adjustment mechanism can be illustrated using the Phillips curve model also. When shifts, the shifts in the opposite direction, as summarized in the table below:
|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 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).
- 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%.
- 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?
a) The short-run Phillips curve (SRPC)? Explain.
b) The long-run Phillips curve (LRPC)? Explain.
Want to join the conversation?
- Why do the wages increase when the unemplyoment decreases?(3 votes)
- I believe that there are two ways to explain this, one via what we just learned, another from prior knowledge. From prior knowledge: if everyone is looking for a job because no one has one, that means jobs can have lower wages, because people will try and get anything. The opposite is true when unemployment decreases; if an employer knows that the person they are hiring is able to go somewhere else, they have to incentivize the person to stay at their new workplace, meaning they have to give them more money. From new knowledge: the inflation rate is directly related to the price level, and if the price level is generally increasing, that means the inflation rate is increasing, and because the inflation rate and unemployment are inversely related, when unemployment increases, inflation rate decreases. In other words, since unemployment decreases, inflation increases, meaning regular inputs (wages) have to increase to correspond to that.(8 votes)
- "When people expect there to be 7% inflation permanently, SRAS will decrease (shift left) and the SRPC shifts to the right."
"When people expect there to be 3% inflation permanently, SRAS will increase (shift right) and the SRPC shifts to the left."
- If I expect there to be higher inflation permanently, then I as a worker am going to be pretty insistent on getting larger raises on an annual basis because if I don't my real wages go down every year.
For the SRAS, this means that the cost of labor will be higher, and remember that an increase in the cost of a resource shifts the SRAS down.
Eventually the SRAS shifts enough that the economy returns to long-run equilibrium. And that means the unemployment rate returns to the natural rate of unemployment, but notice that there is a new, higher price level! The "new normal" for the economy is the same old natural rate of unemployment, but a higher permanent rate of inflation. So, next time there is a recession and the unemployment rate increases and inflation decreases, it will be at a higher rate then whatever the "old normal" was before. The new SRPC reflects that.(8 votes)
- Why Phillips Curve is vertical even in the short run(2 votes)
- Hello Baliram,
I think you meant the Long Run as the Short Run Phillips curve is not vertical!
As for the reasons that the LRPC (long-run Phillips curve) is vertical it is because is equal to the the natural rate of unemployment in a given economy.(5 votes)
- is there a relationship between changes in LRAS and LRPC?(3 votes)
- Yes, there is a relationship between LRAS and LRPC. This is because the LRPC is on the natural rate of unemployment, and so is the LRPC. Thus, a rightward shift in the LRAS line would mean a leftward shift in the LRPC line, and vice versa.(1 vote)
- Now assume instead that there is no fiscal policy action. Will the short-run Phillips curve
shift to the right, shift to the left, or remain the same over time? Explain.(3 votes)
- What is the relationship between the LRPC and the LRAS?(1 vote)
- LRAS is full employment output, and LRPC is the unemployment rate that exist (the natural rate of unemployment) if you make that output.
For example, suppose you knew that full employment output in your economy is making 100 million widgets. Suppose you also know that if you make 100 million widgets, there will still be 4% unemployment. Then the LRAS is vertical at the value of 100 million widgets and the LRPC is vertical at 4% unemployment.(3 votes)
- Why is the x- axis unemployment and the y axis inflation rate?(0 votes)
- Because the point of the Phillips curve is to show the relationship between these two variables. There is no hard and fast rule that you HAVE to have the x-axis as unemployment and y-axis as inflation as long as your phillips curves show the right relationships, it just became the convention. But stick to the convention. It just looks weird to economists the other way.(2 votes)
- What happens if no policy is taken to decrease a high unemployment rate?(1 vote)
- Hi Remy, I guess "high unemployment" means an unemployment rate higher than the natural rate of unemployment. In that case, the economy is in a recession gap and producing below it's potential. which means, AD and SRAS intersect on the left of LRAS. Then if no government policy is taken, The economy will gradually shift SRAS to the right to meet the long-run equilibrium, which is the LRAS and AD intersection.(1 vote)