Expansionary Policy: Short Run vs Long Run

Expansionary Policy: Short Run vs Long Run, step by step

1. 1

   Start at the natural rate

   The economy begins on both the short-run and long-run Phillips curves, sitting at the natural rate of unemployment. Actual inflation equals expected inflation, so workers and firms are not being surprised.

2. 2

   Policy stimulates demand

   The government or central bank runs expansionary policy, boosting aggregate demand. Because actual inflation now rises above the inflation people expected, firms hire more and unemployment falls below the natural rate. This is a movement up and to the left ALONG the current short-run Phillips curve, not a shift of it.

3. 3

   Expectations catch up

   Workers and firms notice the higher inflation and build it into wage demands and prices, so expected inflation rises. Higher expected inflation shifts the short-run Phillips curve up and to the right, meaning more inflation at every unemployment rate.

4. 4

   Back to the natural rate

   As the new short-run curve settles, unemployment climbs back to the natural rate defined by the vertical long-run Phillips curve, but now at a higher inflation rate. The economy ends on the LRPC again, having traded permanently higher inflation for only a temporary fall in unemployment.

Where it ends up

In the long run the economy returns to the natural rate of unemployment, so expansionary policy leaves inflation permanently higher with no lasting drop in unemployment.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

• New Wage Contracts →
• Faster Job Matching →
• Persistent Energy Shock →

More Phillips Curve walkthroughs

• Falling Inflation Expectations →