The Two Phillips Curves & the Role of Expectations

You’ll be able to

Distinguish the short-run from the long-run Phillips curve
Explain why the long-run curve is vertical at the natural rate
Predict how a change in inflation expectations shifts the short-run curve

The short-run trade-off exists because expectations lag

The short-run Phillips curve (SRPC) slopes downward: higher inflation comes with lower unemployment. The reason is that wages are set on expected inflation. When actual inflation exceeds expectations, real wages fall without anyone agreeing to it, firms find labor cheap, hiring rises and unemployment falls. The trade-off is entirely a product of the gap between what people expected and what happened. Close that gap and it disappears.

The long-run curve is vertical

Given time, workers notice and demand wages that reflect actual inflation. Real wages return to where they were, employment returns to its previous level, and unemployment returns to the natural rate — but now with higher inflation permanently embedded. So the long-run Phillips curve (LRPC) is vertical at the natural rate: there is no permanent trade-off. Any inflation rate is compatible with the natural rate of unemployment, which is why sustained stimulus buys inflation and nothing else.

The two curves, mapped to AD–AS

SRPC ↔ SRAS (both rest on sticky wages) · LRPC ↔ LRAS (both vertical, both at the natural level)

They are the same model in different coordinates. A rightward AD shift is a movement up-left along the SRPC.

What shifts the short-run curve

The SRPC shifts when expected inflation changes or when a supply shock hits. Higher expected inflation shifts it up and right — every unemployment rate now comes with more inflation, which is the stagflation of the 1970s in one sentence. A negative supply shock does the same. The LRPC moves only when the natural rate itself changes, through better job matching, retraining, or demographic and institutional shifts — never through demand policy.

Worked example

A central bank repeatedly stimulates the economy to hold unemployment below the natural rate. Trace the short-run and long-run outcomes.

1.Initially, actual inflation exceeds expectations: real wages fall, firms hire, unemployment drops below the natural rate. A movement up-left along the SRPC.
2.Workers observe the higher inflation and revise expectations upward.
3.Wage demands rise, real wages recover, and firms cut employment back — unemployment returns to the natural rate.
4.Higher expected inflation shifts the SRPC up and right.
5.Repeating the stimulus repeats the cycle from a higher starting point.

Answer: Short run: lower unemployment with higher inflation. Long run: unemployment back at the natural rate with permanently higher inflation. Each repetition ratchets inflation up without any lasting employment gain — the case against using demand policy to target unemployment below the natural rate.

Watch out

Movement along the SRPC and a shift of the SRPC are different events with opposite implications. A demand change moves you along it; an expectations change or supply shock shifts it. Stagflation is a shift, not a movement.

Checkpoint

The long-run Phillips curve is vertical because in the long run:

Checkpoint

An increase in expected inflation causes the short-run Phillips curve to:

Checkpoint

Which would shift the long-run Phillips curve to the left?

On the exam

Phillips curve free responses often pair with AD–AS. Keep the correspondence in mind: a rightward AD shift is a move up-left along the SRPC, and a leftward SRAS shift is an outward shift of the SRPC.

Answer the 3 checkpoints as you read.