LRC - Phillips Curve Lesson

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Phillips Curve 

Introduction

Who is this Phillip guy and what's the big deal with his curve?

The Phillip’s curve relationship was first proposed by A.W. Phillips in 1958. Following up on Phillip’s research, other economists found an inverse relationship between the inflation rate and the unemployment rate. In other words, when inflation increased, the unemployment rate decreased, and when inflation decreased, the unemployment rate increased. A graphic representation of this trade-off became known as the Phillips Curve. 

StabilizationPolicies_ExamplePhillipsCurve.png 

 

The Short and Long Run

Long-Run Phillips Curve

The long-run Phillips curve (LRPC) represents the relationship between unemployment and inflation after the economy has adjusted to inflationary expectations. The LRPC corresponds to the long-run aggregate supply (LRAS) and occurs at the nonaccelerating inflation rate of unemployment (NAIRU). The NAIRU corresponds to the full employment level of output and the natural rate of unemployment. Trying to keep the unemployment rate below the NAIRU leads to accelerating inflation rates and cannot be maintained in the long run. Unemployment rates above NAIRU will lead to accelerating deflation that cannot be maintained.
The LRPC is vertical because any employment rate above or below the NAIRU cannot be maintained. This means that there is no long-run trade-off between inflation and unemployment- that is, no policy can maintain unemployment rates below the NAIRU in the long run.

Short Run Phillips Curve

The short-run Phillips curve (SRPC) is drawn for a given expected rate of inflation and a specific natural rate of unemployment. Changes in inflationary expectations will shift the SRPC. People base their inflationary expectations on information and personal experience, which can result in gaps between the expected rate of inflation and the actual rate of inflation.

Review the activity below.

Economists have concluded that two factors cause the Phillips curve to shift.

  • The first is supply shocks, like the Oil Crisis of the mid-1970s, which first brought stagflation into our vocabulary.
  • The second is changes in people’s expectations about inflation.

In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors (supply shocks and changes in inflationary expectations) cause the aggregate supply curve, and thus the Phillips curve, to shift.

In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).

Watch the presentation below to learn more about the Phillip's Curve.

A Phillips curve shows the tradeoff between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower inflation, and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years.

Watch the video below to learn more.

 

 

Review

Review what you have learned by completing the activity below.

 

In Summary . . .

  • What's Your takeaway? Icon The Phillips curve illustrates the short-run relationship between inflation and unemployment.
  • The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.
  • The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.
  • A higher level of output results in a lower level of unemployment.
  • The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

Long Run Phillips Curve

  • In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
  • As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.
  • Monetary policy could be effective in the short run but not in the long run.

Short Run Phillips Curve

  • Expected inflation measures how much people expect the overall price level to change.
  • In the long run, expected inflation adjusts to changes in actual inflation.
  • The Fed’s ability to create unexpected inflation exists only in the short run.

 

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