5.2 The Phillips Curve

Short-Run Phillips Curve

The short-run Phillips curve (SRPC) shows an inverse relationship between inflation and unemployment. Expansionary policy that lowers unemployment tends to raise inflation, and contractionary policy that lowers inflation tends to raise unemployment. This tradeoff exists because unexpected changes in aggregate demand move the economy along the SRPC, corresponding to shifts along the short-run aggregate supply curve.

Long-Run Phillips Curve

In the long run, there is no tradeoff between inflation and unemployment. The long-run Phillips curve (LRPC) is a vertical line at the natural rate of unemployment (NRU), since output returns to potential once expectations adjust. Any inflation rate is consistent with the natural rate, meaning monetary policy cannot permanently lower unemployment below the NRU.

Shifts and Expectations

The SRPC shifts when expected inflation changes or supply shocks occur. If expected inflation rises, the entire SRPC shifts rightward/upward, worsening the tradeoff (stagflation). Adaptive expectations mean workers/firms adjust wage and price expectations based on past inflation, causing the economy to settle back at the NRU on a new SRPC after temporary deviations from unemployment.

Key terms

Short-Run Phillips Curve (SRPC)

A curve showing the inverse relationship between inflation and unemployment in the short run.

Long-Run Phillips Curve (LRPC)

A vertical line at the natural rate of unemployment; no long-run tradeoff between inflation and unemployment.

Natural Rate of Unemployment (NRU)

The unemployment rate that exists when the economy is producing at potential output, consisting of frictional and structural unemployment.

Stagflation

Simultaneous increase in inflation and unemployment, often caused by adverse supply shocks shifting the SRPC outward.

Adaptive Expectations

The theory that people form expectations about future inflation based on recent past inflation experiences, causing SRPC shifts over time.

Try an AP-style question

The short-run Phillips curve shows a trade-off between…

1. inflation and unemployment
2. interest and investment
3. GDP and prices
4. exports and imports