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The Phillips Curve: Balancing Inflation and Unemployment
Dive into the Phillips Curve theory and its impact on economic policy. Understand the relationship between inflation and unemployment rates, and how it affects macroeconomic decisions.

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Now Playing:Philips curve – Example 0a
Intros
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  1. Short-Run Philips Curve
    • Two Time frames of Philips Curve
    • Expected Inflation Rate
    • Natural Unemployment Rate
    • U-Shaped
  2. Long-Run Philips Curve
    • Actual Inflation = Expected Inflation Rae
    • Vertical Line
    • Any Expected Inflation is possible
Inflation cycles
Jump to:NotesConceptFAQsPrerequisites
Notes
Another way to study Inflation cycles is to look at the trade-off between unemployment and inflation.

What happens to the unemployment rate when inflation is high? What if inflation is low? To understand this, we look at Philips Curve.

There are two-time frames of Philips Curves:
  1. Short-Run Philips Curve
  2. Long-Run Philips Curve


Short-Run Philips Curve

Short-Run Philips Curve: is the relationship between unemployment and inflation, while holding expected inflation and the natural unemployment rate constant.

The following graph shows the short-run Philips Curve:

Philips Curve

Notice that
  1. Curve is U-Shaped.
  2. At point A, expected inflation rate is 3%, unemployment rate is 3%
  3. Aggregate demand  ↑  \, \uparrow \, , then unemployment  ↓  \, \downarrow \, & inflation  ↑  \, \uparrow \, . This is a movement up along the curve.
  4. Aggregate demand  ↓  \, \downarrow \, , then unemployment  ↑  \, \uparrow \, & inflation  ↓  \, \downarrow \, . This is a movement up along the curve.


Long-Run Philips Curve

Long-Run Philips Curve: is the relationship between inflation and unemployment when the expected inflation rate = actual inflation rate.

The following graph shows the long-run Philips Curve:

Philips Curve

Notice that
  1. The curve is a vertical line
  2. The curve is vertical at the natural unemployment rate
  3. Any expected inflation rate is possible at the natural unemployment rate


Short-Run, Long-Run Philips Curve & Its Changes

Now that we learned about short-run Philips curve, and long-run Philips curves, we can put them together in a graph.

Philips Curve

The short-run Philips curve and the long-run Philips curve intersects at the expected inflation rate.

Changes to the Expected Inflation Rate

When the expected inflation rate increases or decreases, it changes the Philips curves.

Case 1: Suppose the expected inflation rate increases.

The long-run Philips curve does not change, but the short-run Philips curves shifts right.

Philips Curve

Case 2: Suppose the expected inflation rate decreases.

The long-run Philips curve does not change, but the short-run Philips curves shifts downward.

Philips Curve

Changes to the Natural Unemployment Rate

When the natural rate of unemployment changes, it can also affect the Philips curves.

Case 1: Suppose the natural rate of unemployment increases.

Then the long-run Philips curve shifts rightward, and the short-run Philips curve also shifts right.

Philips Curve

We see that there is no effect to the expected inflation rate because it is constant.

Case 2: Suppose the natural rate of unemployment decreases.

Then the long-run Philips curve shifts leftward, and the short-run Philips curve shifts down.

Philips Curve

Once again, there are no changes to the expected inflation rate, but the unemployment rate has decreased.
Concept

Introduction to the Phillips Curve

The Phillips curve is a fundamental concept in economics that explores the relationship between unemployment and inflation. Named after economist William Phillips, this theory suggests an inverse correlation between these two key economic indicators. The Phillips curve posits that as unemployment decreases, inflation tends to rise, and vice versa, creating a trade-off that policymakers must navigate. This trade-off has significant implications for economic policy decisions and has been a subject of extensive debate among economists. Understanding the Phillips curve is crucial for grasping the complexities of macroeconomic management and the challenges faced by central banks and governments in maintaining economic stability. To help you grasp these concepts more easily, we've included an introductory video that explains the Phillips curve, unemployment, inflation, and their interplay in a clear and concise manner. This video will provide you with a solid foundation for understanding these important economic principles and their real-world applications.

FAQs

  1. What is the Phillips curve?

    The Phillips curve is an economic concept that illustrates the inverse relationship between unemployment and inflation rates. It suggests that as unemployment decreases, inflation tends to increase, and vice versa. This relationship is typically observed in the short run but becomes more complex in the long run.

  2. How does the short-run Phillips curve differ from the long-run Phillips curve?

    The short-run Phillips curve shows a negative relationship between unemployment and inflation, implying a trade-off between the two. In contrast, the long-run Phillips curve is vertical, suggesting that there is no trade-off between unemployment and inflation in the long term. The long-run curve intersects the x-axis at the natural rate of unemployment, regardless of the inflation rate.

  3. What is the natural rate of unemployment?

    The natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), is the level of unemployment that exists in an economy when it is in equilibrium. It represents the unemployment rate that would persist even when the economy is operating at full capacity, due to factors such as frictional and structural unemployment.

  4. How has the Phillips curve theory been challenged?

    The Phillips curve theory has been challenged by events such as stagflation in the 1970s, where high unemployment and high inflation coexisted. Critics argue that it oversimplifies complex economic dynamics and fails to account for factors like expectations and structural changes. Modern interpretations have adapted the theory to incorporate these factors and explain phenomena like the "missing inflation" puzzle observed after the Great Recession.

  5. What are the implications of the Phillips curve for economic policy?

    The Phillips curve has significant implications for monetary and fiscal policy. In the short run, it suggests that policymakers may face a trade-off between reducing unemployment and controlling inflation. However, the long-run perspective indicates that attempts to maintain unemployment below its natural rate through expansionary policies may lead to accelerating inflation without sustained employment benefits. This understanding encourages policymakers to focus on structural reforms that address the natural rate of unemployment rather than relying solely on demand-side interventions.

Prerequisites

Understanding the Phillips curve requires a solid foundation in various economic concepts. While there are no specific prerequisite topics provided for this article, it's important to recognize that economics is an interconnected field where many concepts build upon one another. A strong grasp of fundamental economic principles is essential for comprehending the Phillips curve and its implications.

The Phillips curve, named after economist William Phillips, is a crucial concept in macroeconomics that explores the relationship between unemployment rates and inflation. To fully appreciate this concept, students should have a good understanding of basic economic principles, such as supply and demand, market equilibrium, and the factors that influence economic growth.

One key area that relates closely to the Phillips curve is labor economics. Understanding how labor markets function, including concepts like wage determination, labor force participation, and unemployment types, provides valuable context for analyzing the Phillips curve. These topics help explain why there might be a trade-off between inflation and unemployment in the short run.

Another important prerequisite area is monetary policy. The Phillips curve is often used by central banks when making decisions about interest rates and money supply. Therefore, having knowledge of how monetary policy works, including the roles of central banks and the tools they use to influence the economy, is crucial for grasping the practical applications of the Phillips curve.

Inflation is a central component of the Phillips curve, so a solid understanding of what inflation is, how it's measured, and its effects on the economy is essential. This includes familiarity with concepts like the Consumer Price Index (CPI) and the various causes of inflation, such as demand-pull and cost-push factors.

Additionally, knowledge of macroeconomic indicators and how they interrelate is valuable when studying the Phillips curve. This includes understanding Gross Domestic Product (GDP), economic growth rates, and business cycles. These concepts help provide the broader economic context in which the Phillips curve operates.

While specific prerequisite topics weren't provided, it's clear that a well-rounded understanding of economic principles is crucial for mastering the Phillips curve concept. Students should focus on building a strong foundation in these areas to fully appreciate the nuances and implications of the Phillips curve in modern economic theory and policy-making.

By thoroughly grasping these interconnected economic concepts, students will be better equipped to analyze and interpret the Phillips curve, its historical significance, and its relevance in contemporary economic discussions. This comprehensive understanding will enable them to engage more deeply with advanced economic theories and policy debates surrounding inflation, unemployment, and overall economic stability.