Phillips Curve
What is Phillips Curve?
The Phillips curve shows the short-run inverse relationship between the inflation rate and the unemployment rate.
In the short run, lower unemployment tends to come with higher inflation, giving policymakers a trade-off. The long-run Phillips curve is vertical at the natural rate of unemployment, so there is no permanent trade-off: pushing unemployment below the natural rate only raises inflation. It is the inflation-unemployment counterpart of the AD-AS model.
Phillips Curve: a worked example
An economy is producing at potential output of 800 billion dollars with unemployment at its natural rate of 5 percent and inflation at 2 percent. A surge in consumer confidence shifts aggregate demand right, pushing real output to 840 billion dollars, an inflationary gap of 840 - 800 = 40 billion dollars. Firms hire to meet the extra orders, so unemployment falls to 3 percent, and competition for scarce labor and materials lifts inflation to 6 percent. On the Phillips curve this single event is one move along the short run curve, from the point at 5 percent unemployment and 2 percent inflation up and to the left to 3 percent unemployment and 6 percent inflation. The economy traded 2 percentage points of unemployment for 4 percentage points of inflation, a ratio of 2 to 1.
The mistake students make with phillips curve
Drawing the axes backwards. Unemployment goes on the horizontal axis and the inflation rate on the vertical axis, so an expansion moves the point up and to the left. Students who put inflation on the horizontal axis end up describing stimulus as a move down and to the right, then contradict themselves when they translate the answer back to the AD-AS graph. A second version of the error is reading the downward slope as causation, as though inflation itself creates jobs. Aggregate demand is doing the work, and both variables respond to it.
Phillips Curve questions
What does the Phillips curve show?
The Phillips curve plots the inflation rate against the unemployment rate. In the short run the two move in opposite directions, so periods of falling unemployment tend to arrive with rising inflation. The curve gives policymakers an apparent menu of combinations, though only while inflation expectations stay put. Over the long run the relationship disappears and the curve becomes vertical at the natural rate of unemployment, which means no permanent trade-off exists.
How does the Phillips curve connect to the AD-AS model?
Every AD-AS movement has a Phillips curve twin. A rightward shift in aggregate demand raises the price level and real output, which on the Phillips curve is a move up and to the left along the short run curve. A leftward supply shock raises the price level while cutting output, which shifts the short run Phillips curve right and produces higher inflation with higher unemployment. Long run aggregate supply at potential output corresponds to the vertical long run Phillips curve at the natural rate.
Is the trade-off between inflation and unemployment real?
A genuine trade-off exists in the short run only. While wage contracts and price expectations are fixed, stimulus that raises spending does lower unemployment and does raise inflation together. Once expectations catch up to the new inflation rate, wages adjust and unemployment drifts back to its natural rate with nothing gained. So policymakers can borrow lower unemployment for a while, but they repay it in permanently higher inflation rather than keeping it.
Formula / Example
This is the live Phillips Curve sandbox. Drag the curves, or open the full version.
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