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The Phillips Curve

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The short-run trade-off

The short-run Phillips curve (SRPC) shows an inverse relationship between the inflation rate and the unemployment rate: when unemployment is low, inflation tends to be high, and vice versa. This is the mirror image of the AD–AS model. A rightward shift of AD raises output and the price level (higher inflation) while lowering unemployment — a movement up and to the left along the SRPC. A leftward AD shift does the reverse. The SRPC captures the short-run trade-off policymakers face: stimulating demand to cut unemployment tends to raise inflation.

The vertical long-run Phillips curve

In the long run there is no trade-off. The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment, corresponding to potential output (LRAS). Once inflation is fully anticipated, workers and firms adjust wages and prices, and unemployment returns to its natural rate regardless of the inflation rate. Just as LRAS is vertical at potential output, the LRPC is vertical at the natural rate — attempts to hold unemployment below the natural rate only produce accelerating inflation, not a permanent job gain.

Shifts of the Phillips curve

A supply shock shifts the short-run Phillips curve itself. A negative supply shock (say, rising oil prices) raises both inflation and unemployment at once — stagflation — shifting the SRPC outward (right). This corresponds to a leftward shift of SRAS. A change in the natural rate of unemployment shifts the long-run Phillips curve: if structural unemployment falls (better job matching, retraining), both the LRPC and the SRPC shift left. Movements along the SRPC come from AD changes; shifts come from supply shocks or a changed natural rate.

Phillips curve ↔ AD–AS correspondence
AD ↑ ⇒ move up-left along SRPC (inflation ↑, unemployment ↓) · negative supply shock ⇒ SRPC shifts right
Demand changes are movements along the SRPC; supply shocks shift it. The LRPC sits vertically at the natural rate of unemployment.
Worked example

An economy sits at the natural rate of unemployment (5%) with 2% inflation. The government sharply increases spending, shifting AD right. Describe the short-run and long-run outcomes on the Phillips curve.

  1. 1.The rightward AD shift raises real GDP and the price level: inflation rises above 2%, and unemployment falls below 5%.
  2. 2.On the SRPC, this is a movement up and to the left to a point like (unemployment 3%, inflation 4%).
  3. 3.In the long run, wages and expectations adjust to the higher inflation; SRAS shifts left and unemployment returns to the natural rate.
  4. 4.The economy ends back on the vertical LRPC at 5% unemployment but with permanently higher inflation.
Answer: Short run: a movement up-left along the SRPC — lower unemployment (below 5%) but higher inflation. Long run: unemployment returns to the natural rate of 5% on the vertical LRPC, leaving only higher inflation. There is no permanent trade-off.
Checkpoint

A negative supply shock (a sharp rise in oil prices) hits the economy. What happens on the short-run Phillips curve?

Watch out

Only AD changes move you along the short-run Phillips curve. A supply shock shifts the SRPC (both inflation and unemployment move the same direction). Treating stagflation as a movement along the curve is a classic error.

Checkpoint

The long-run Phillips curve is vertical at the natural rate of unemployment. What does this imply about attempts to permanently reduce unemployment below the natural rate through expansionary policy?

On the exam

Pair the Phillips curve with AD–AS in your answers. A rightward AD shift = up-left move along the SRPC; a leftward SRAS shift (supply shock) = an outward shift of the SRPC. Consistency between the two models earns full credit.

Answer the 2 checkpoints as you read.

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