The Phillips Curve
Imagine the Fed announces that it wants unemployment as low as possible. Sounds great, right? But your grocery bill, your gas prices, and your rent might climb faster. Is there a price to pay for low unemployment? And can the economy keep unemployment low forever? The Phillips curve is the graph economists use to answer both questions. By the end of this page, you will be able to say who pays, and for how long.
The short-run Phillips curve
The short-run Phillips curve (SRPC) shows the tradeoff between the unemployment rate (horizontal axis) and the inflation rate (vertical axis) in the short run. It slopes downward: lower unemployment goes with higher inflation, and higher unemployment goes with lower inflation.
Why? Think of the AD–AS model. Suppose aggregate demand increases. Firms in a town in Ohio sell more, so they hire more workers (unemployment falls) and the price level rises (inflation goes up). If aggregate demand decreases, output falls, unemployment rises, and inflation slows.
Moving from A to B to C means moving along the SRPC: unemployment falls and inflation rises. A change in AD causes a movement along the SRPC. In the graph, A is at 6% unemployment and 2% inflation, B at 5% and 3%, and C at 4% and 5%. From A to C, unemployment falls 2 percentage points and inflation rises 3 percentage points. At C, unemployment is below the natural rate (5%), so real GDP is above potential: an inflationary gap.
The natural rate of unemployment is 5%. Along a given SRPC, the unemployment rate falls from 6% to 4%. What happens to the inflation rate, and what type of movement is…
The natural rate of unemployment is 5%. Along a given SRPC, the unemployment rate falls from 6% to 4%. What happens to the inflation rate, and what type of movement is this (a movement along the curve or a shift of the curve)?
The long-run Phillips curve
In the long run, wages and prices fully adjust, and the economy returns to producing potential output. Unemployment goes back to the natural rate of unemployment (frictional plus structural unemployment, with zero cyclical unemployment). So the long-run Phillips curve (LRPC) is a vertical line at the natural rate.
This matches the vertical LRAS curve: both say that, in the long run, policy cannot permanently push the economy beyond its potential. Higher inflation does not buy lower unemployment forever. There is no long-run tradeoff between inflation and unemployment.
Define the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC). Say where the LRPC is located and what it shows about the long-run tradeoff.
Define the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC). Say where the LRPC is located and what it shows about the long-run tradeoff.
An SRPC contains these points. | Point | Unemployment rate | Inflation rate | |---|---|---| | A | 6% | 2% | | B | 5% | 3% | | C | 4% | 5% | The natural rate of…
An SRPC contains these points.
| Point | Unemployment rate | Inflation rate |
|---|---|---|
| A | 6% | 2% |
| B | 5% | 3% |
| C | 4% | 5% |
The natural rate of unemployment is 5%. (a) At which point is the economy at the natural rate? (b) Describe what is likely true about real GDP relative to potential at point C. (c) Explain what happens to the SRPC and to unemployment in the long run if the economy remains at point C and workers begin to expect higher inflation.
Movements along vs. shifts of the SRPC
Two things shift the SRPC:
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Expected inflation. If workers and firms expect higher inflation, they build it into wage contracts and prices. At every unemployment rate, actual inflation is higher, so the SRPC shifts up. Lower expected inflation shifts it down.
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Supply shocks. A negative supply shock (higher oil prices after a hurricane damages Gulf Coast refineries) raises costs, so at every unemployment rate inflation is higher: the SRPC shifts up. A positive supply shock shifts it down.
A change in AD, by contrast, moves the economy along the SRPC.
| Event | AD–AS effect | Phillips curve |
|---|---|---|
| AD increases | PL up, real GDP up | Move along SRPC: unemployment down, inflation up |
| AD decreases | PL down, real GDP down | Move along SRPC: unemployment up, inflation down |
| SRAS decreases (negative supply shock) | PL up, real GDP down | SRPC shifts up: stagflation |
| SRAS increases | PL down, real GDP up | SRPC shifts down |
| Expected inflation rises | Wages rise, SRAS decreases | SRPC shifts up |
Decide whether each event is a movement along the SRPC or a shift of the SRPC. (a) Expected inflation rises. (b) A negative supply shock raises input costs. (c) An…
Decide whether each event is a movement along the SRPC or a shift of the SRPC. (a) Expected inflation rises. (b) A negative supply shock raises input costs. (c) An increase in aggregate demand pushes unemployment below the natural rate.
For each shock, describe the effect on the price level and real GDP in the AD-AS model, and the corresponding effect on the Phillips curve diagram (a movement along or a…
For each shock, describe the effect on the price level and real GDP in the AD-AS model, and the corresponding effect on the Phillips curve diagram (a movement along or a shift of the SRPC). (a) An increase in aggregate demand. (b) A decrease in SRAS from higher oil prices.
Long-run adjustment and expectations
Suppose the economy is at the natural rate of 5% unemployment, with expected inflation of 2% and actual inflation of 2%. Now the Fed expands the money supply, and AD rises. The economy moves up along the SRPC to 4% unemployment and 4% inflation.
At 4% unemployment, there is an inflationary gap. Workers see prices rising faster than they expected, so they demand higher wages. Expected inflation rises toward 4%. Wages rise, SRAS decreases, and unemployment climbs back to 5%. On the graph, the SRPC shifts up. The new SRPC crosses the LRPC at 5% unemployment and 4% inflation.
The path is A → B (short run, along SRPC₁) → C (long run, on SRPC₂). The result: unemployment is back at the natural rate, and the only lasting effect is higher inflation. That is why relying on expansionary policy alone fails in the long run.
The natural rate of unemployment is 5%, and expected inflation is 2%. The economy is at an unemployment rate of 4% and an inflation rate of 4%. (a) Is the economy above…
The natural rate of unemployment is 5%, and expected inflation is 2%. The economy is at an unemployment rate of 4% and an inflation rate of 4%. (a) Is the economy above or below the LRPC, and is there a recessionary or inflationary gap? (b) Explain what happens to expected inflation, to the SRPC, and to unemployment in the long run. (c) What is the long-run inflation rate if expectations fully adjust to 4%?
The natural rate of unemployment is 5%, and expected and actual inflation are both 6%. The Fed wants to reduce inflation to 2% through contractionary monetary policy.…
The natural rate of unemployment is 5%, and expected and actual inflation are both 6%. The Fed wants to reduce inflation to 2% through contractionary monetary policy. (a) Using the SRPC and LRPC, explain the short-run cost in terms of unemployment as the economy moves along the SRPC. (b) Explain how expectations and the SRPC change over time as inflation falls. (c) Explain why a credible announcement of the policy could reduce the unemployment cost. (d) State the final long-run unemployment rate and inflation rate.
Stagflation and the policy dilemma
In the 1970s, rising oil prices shifted SRAS left. Real GDP fell (unemployment rose from 5% to 7%) and the price level rose (inflation went from 2% to 6%). On the Phillips curve diagram, the SRPC shifted up, so the economy moved to a point with both higher unemployment and higher inflation. This is stagflation.
Policymakers then face a dilemma:
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Expansionary policy lowers unemployment but raises inflation further.
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Contractionary policy lowers inflation but raises unemployment further.
Either choice makes one problem worse. And the LRPC says that pushing unemployment below the natural rate through expansion cannot last: expectations rise, the SRPC shifts up more, and you are left with higher inflation at the same natural rate. In the long run, the economy returns to the LRPC (the natural rate) once SRAS recovers or expectations adjust.
In the 1970s, rising oil prices pushed the economy from an unemployment rate of 5% and inflation of 2% to an unemployment rate of 7% and inflation of 6%. (a) Explain…
In the 1970s, rising oil prices pushed the economy from an unemployment rate of 5% and inflation of 2% to an unemployment rate of 7% and inflation of 6%. (a) Explain this episode using the AD-AS model and the Phillips curve. (b) Explain why policymakers face a dilemma, describing what expansionary and contractionary policy would each do to unemployment and inflation in the short run. (c) Explain what the long-run Phillips curve implies about relying on expansionary policy alone.
Summary
Back to the start: low unemployment can cost you higher inflation in the short run, but not in the long run, when unemployment returns to its natural rate and only higher inflation remains.