The Phillips Curve

Unit 10 - Lesson 6

Learning outcomes:

Discuss, using a short-run Phillips curve diagram, the view that there is a
possible trade-off between the unemployment rate and the inflation rate in the
short-run.
Explain using a diagram that the short run Phillips curve may shift outwards
resulting in stagflation (shifts in SRAS).
Discuss using a diagram the view that there is a long-run Phillips curve that is
vertical at the NRU & therefore there is no trade-off between the employment
rate & inflation in the long-run.
Explain using NRU is the rate of employment in an economy when the
economy is producing at the full level of output.

Phillips Curve
Concerned with the relationship between the Inflation Rate and
Unemployment.
The Economist Phillips stated there appeared to be a negative
relationship between unemployment rates and inflation.
Lower the rate of inflation - the higher the rate of
unemployment
Higher the rate of inflation - the lower the rate of unemployment

Every economy faces a trade off between

inflation and unemployment

Short run Phillips Curve

Vertical Axis: Inflation Rate
Horizontal Axis: Unemployment
Inverse relationship shows that as
Unemployment decreases the
Inflation Rate will increase in the
Short-run.
http://www.personal.psu.
edu/~dxl31/econ4/Fall_2014/phillips2.png

Relationship: AD - AS & Short-run Phillips Curve

An increase or decrease in AD there will
result in a movement along the Short run
Phillips Curve (SRPC).
An increase in AD leads to Increase in Price
Levels and Increase in Real GDP.
Increase in Price Levels - Inflation
Increase in Real GDP - decrease in
unemployment
A movement along the SRPC from Point a - b

http://www.personal.psu.
edu/~dxl31/econ4/Fall_2014/phillips
2.png

Decrease in AD & the SRPC

Decrease in AD leads to a decrease in Price
Levels and a decrease in Real GDP
Decrease in Price level - decrease in the
rate of inflation (disinflation) from 6% - 2%
Decrease in Real GDP leads to a
increase in the rate of unemployment
from 3% - 5%. Less workers necessary
to produce the output.
Decrease in AD leads to a movement
along the SRPC from Point B - A.

https://figures.boundless.
com/20829/large/philips-curve.png

Shifts in the Short-run Phillips Curve (SRPC)

Supply Shocks decrease the SRAS (shift
left) resulting in Increased Price Level and a
decrease in the Real GDP - Stagflation.
Increase in Price Levels - Inflation
Decrease in Real GDP results in less of
a demand for workers and an Increase
in the Unemployment Rate.

Decrease in the SRAS shifts the

SRPC outwards moving from
Point A - B

http://www.personal.psu.
edu/~dxl31/econ4/Fall_2014/phillips3.png

Long-run Phillips Curve

Milton Friedman argued that the trade off between Inflation
and Unemployment is not permanent.
Enter the Long-run Phillips Curve.
In the long run the negative relationship between
unemployment & inflation no longer holds.
Long run Phillips curve is vertical at Full Employment or the
Natural Rate of Unemployment.

Assuming New Classical Model we know:

1.
2.
3.

Increase in AD leads to an Inflationary Gap

(Point A - B)
Due to the lack of workers, wages are forced
up.
Increases the Cost of Production & increases
the SRAS (Point B - C)

Effect on the Phillips Curve:

1. Increase AD - Increase in
Price Levels - Inflation.
2. Increase AD - movement
along the SRPC (a - b)
decreasing unemployment &
increasing inflation rate.
3. The Increase in the SRAS
leads to an outward shift
from SRPC1 -SRPC2 to
point c.
4. Economy returns to NRU
with increased inflation rate.