5.2 - The Phillips Curve

Purpose and components of the Phillips curve

The Phillips curve model illustrates the relationship between inflation and unemployment in an economy. Inflation refers to the rate at which the general level of prices for goods and services rises, while unemployment measures the percentage of the labor force that is jobless and actively seeking work. This model helps explain how changes in economic conditions affect these two key indicators, both in the short run and over longer periods.

Graphical representation

The model uses graphs to show these relationships visually. On a Phillips curve graph, the vertical axis represents the inflation rate (in percent), and the horizontal axis represents the unemployment rate (also in percent). The graph includes two main curves that capture different time perspectives on the economy.

The short-run Phillips curve

The short-run Phillips curve (SRPC) shows the inverse relationship between inflation and unemployment in the short run, a period when prices and wages are sticky and do not adjust immediately to changes.

Key features of the short-run Phillips curve

• Downward-sloping shape - As unemployment decreases, inflation increases, and vice versa. This illustrates a trade-off: lower unemployment often comes with higher inflation.
• Position in the economy - An economy is always operating somewhere along the SRPC, reflecting current economic conditions.
• Graphical representation - The SRPC is drawn as a downward-sloping line from the top-left (high inflation, low unemployment) to the bottom-right (low inflation, high unemployment).

This trade-off occurs because in the short run, increased economic activity can reduce unemployment but also push up prices through higher demand.

The long-run Phillips curve and natural rate

The long-run Phillips curve (LRPC) represents the relationship between inflation and unemployment over the long run, a period when prices and wages fully adjust to economic changes.

Key features of the long-run Phillips curve

• Vertical shape - The LRPC is a vertical line, indicating no long-term trade-off between inflation and unemployment.
• Natural rate of unemployment - This is the unemployment rate that exists when the economy is at full employment, including frictional and structural unemployment but not cyclical unemployment. The LRPC is positioned at this rate, typically around 4-5% in many economies.
• Graphical representation - On the Phillips curve graph, the LRPC appears as a straight vertical line at the natural rate of unemployment, crossing multiple possible inflation rates.

The diagram below shows both curves together. The downward-sloping SRPC gives the short-run trade-off, and the vertical LRPC stands at the natural rate of unemployment U_N. Where they cross, unemployment is at its natural rate and inflation is π₁.

In the long run, unemployment returns to its natural rate regardless of the inflation level, as workers and firms adjust expectations and wages accordingly.

Short-run and long-run equilibrium

Equilibrium in the Phillips curve model occurs when inflation and unemployment are stable given current economic conditions. It can be viewed in both short-run and long-run contexts.

Long-run equilibrium

Long-run equilibrium is the point where the SRPC intersects the LRPC.

At this intersection:

• The unemployment rate equals the natural rate.
• The actual inflation rate matches the expected inflation rate.
• The economy is balanced, with no unexpected shocks driving changes.

Graphically, this is shown as the point where the downward-sloping SRPC crosses the vertical LRPC.

Short-run equilibrium

Short-run equilibrium is any point along the SRPC, which may or may not align with the LRPC.

Deviations from long-run equilibrium create gaps:

• Inflationary gaps - Points to the left of the LRPC, where unemployment is below the natural rate and inflation is higher than expected. This often results from excessive demand.
• Recessionary gaps - Points to the right of the LRPC, where unemployment is above the natural rate and inflation is lower than expected. This typically stems from insufficient demand.

These gaps prompt adjustments over time, moving the economy back toward long-run equilibrium.

Demand and supply shocks on the Phillips curve

Economic shocks are unexpected events that disrupt the economy, affecting the Phillips curve by causing movements or shifts. These changes influence unemployment and inflation differently in the short run and long run.

Demand shocks and movement along the SRPC

Demand shocks involve changes in aggregate demand, such as increased government spending or consumer confidence.

Positive demand shock:

• This moves the economy leftward along the SRPC: unemployment decreases, but inflation increases.
• In the short run, this creates an inflationary gap.
• Over the long run, as expectations adjust, the SRPC shifts upward, returning unemployment to the natural rate at a higher inflation level.

The diagram below follows that through. The economy starts where SRPC₁ crosses the LRPC, with inflation π₁ and unemployment at U_N. A positive demand shock moves it up and to the left along SRPC₁, to the lower unemployment rate U₂ and the higher inflation rate π₂. Expectations then catch up, SRPC₁ shifts up to SRPC₂, and unemployment returns to U_N while inflation stays at π₂.

Negative demand shock:

• This moves the economy rightward along the SRPC: unemployment increases, but inflation decreases.
• In the short run, this leads to a recessionary gap.
• In the long run, the SRPC shifts downward, restoring the natural rate of unemployment at a lower inflation rate.

Supply shocks and shifts of the SRPC

Supply shocks arise from changes in production costs, like oil price spikes or natural disasters.

Negative supply shock:

• This shifts the SRPC upward and to the right: both unemployment and inflation increase in the short run (stagflation).

The diagram below shows it. SRPC₁ moves up and right to SRPC₂, so the economy leaves the natural rate: unemployment rises from U_N to U₂ and inflation rises from π₁ to π₂ at the same time. A demand shock moves the economy along a Phillips curve; a supply shock moves the curve itself, which is why this one worsens both variables at once.

• In the long run, as the economy adjusts, the SRPC may shift back if the shock is temporary, or the LRPC could shift if it affects the natural rate.

Positive supply shock:

• This shifts the SRPC downward and to the left: both unemployment and inflation decrease in the short run.
• Long-run effects depend on whether the natural rate changes.

Factors shifting the LRPC

The LRPC shifts when the natural rate of unemployment changes due to factors like:

• Changes in labor market policies (e.g., unemployment benefits).
• Demographic shifts (e.g., aging population).
• Technological advancements affecting structural unemployment.

A shift rightward increases the natural rate, while a leftward shift decreases it, altering long-run equilibrium.