Core Concepts & Learning Goals
The Phillips Curve illustrates the relationship between a country's inflation rate and its unemployment rate. The central idea is that in the short run, policymakers often face a trade-off: policies that reduce unemployment tend to increase inflation, and vice versa. However, this trade-off disappears in the long run, as the economy adjusts to a natural rate of unemployment regardless of the level of inflation.
By the end of this topic, you will be able to define and graphically represent the short-run and long-run Phillips curves and explain how changes in the aggregate economy—specifically shifts in aggregate demand and aggregate supply—affect these curves.
Key Concepts Breakdown
1. The Short-Run Phillips Curve (SRPC)
The Short-Run Phillips Curve (SRPC) is a graphical model that shows the inverse relationship between the inflation rate and the unemployment rate in the short run.
When unemployment falls, inflation tends to rise.
When unemployment rises, inflation tends to fall.
This trade-off exists because of the relationship between aggregate demand and the economy's output and price level. An increase in aggregate demand boosts production and requires firms to hire more workers, thus lowering unemployment. This same increase in demand also pushes the overall price level up, causing inflation. Conversely, a decrease in aggregate demand reduces production, leading to layoffs (higher unemployment) and less pressure on prices (lower inflation). Therefore, changes in aggregate demand cause a movement along the SRPC.
2. The Long-Run Phillips Curve (LRPC)
The Long-Run Phillips Curve (LRPC) is a vertical line at the economy's Natural Rate of Unemployment (NRU). The NRU is the unemployment rate that persists when the economy is producing at its full-employment output level, accounting for frictional and structural unemployment.
The vertical shape of the LRPC signifies that in the long run, there is no trade-off between inflation and unemployment. While policymakers can use demand-side policies to push unemployment below the NRU temporarily, this effect will not last. Over time, wages and prices adjust to the higher inflation, and the economy returns to the NRU. The NRU is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is the rate of unemployment at which inflation does not tend to increase or decrease.
3. Shifts of the Phillips Curves
While changes in aggregate demand cause movements along the SRPC, other factors cause the entire curve to shift.
Supply Shocks: Events that directly impact producers' costs will shift the short-run aggregate supply (SRAS) curve and, in turn, the SRPC.
A negative supply shock (e.g., a sudden rise in oil prices) increases both inflation and unemployment. This condition is known as stagflation. This event shifts the SRPC to the right.
A positive supply shock (e.g., a technological breakthrough that lowers production costs) decreases both inflation and unemployment, shifting the SRPC to the left.
Inflationary Expectations: What people expect inflation to be in the future is a critical determinant of the SRPC's position.
If workers and firms expect higher inflation, they will negotiate higher nominal wages. This increases production costs, shifting the SRAS curve left and the SRPC to the right.
If inflationary expectations fall, workers will accept lower nominal wage increases, shifting the SRAS curve right and the SRPC to the left.
The table below summarizes the relationship between the AD/AS model and the Phillips curve.
| Economic Event | Impact on AD/AS Model | Impact on Phillips Curve Model |
|---|---|---|
| Increase in Aggregate Demand | AD curve shifts right | Movement up/left along the SRPC |
| Decrease in Aggregate Demand | AD curve shifts left | Movement down/right along the SRPC |
| Negative Supply Shock | SRAS curve shifts left | SRPC shifts right |
| Positive Supply Shock | SRAS curve shifts right | SRPC shifts left |
| Increase in Expected Inflation | SRAS curve shifts left | SRPC shifts right |
| Decrease in Expected Inflation | SRAS curve shifts right | SRPC shifts left |
Graphical Analysis (Text-Only)
The Phillips Curve model is drawn with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis.
Axes:
Vertical axis: Inflation Rate (%)
Horizontal axis: Unemployment Rate (%)
Curves:
Short-Run Phillips Curve (SRPC): A downward-sloping curve, indicating the inverse short-run relationship between inflation and unemployment.
Long-Run Phillips Curve (LRPC): A vertical line located at the Natural Rate of Unemployment (NRU).
Equilibrium Logic:
Long-Run Equilibrium: The economy is in long-run equilibrium where the SRPC intersects the LRPC. At this point, let's call it Point A, the actual unemployment rate is equal to the NRU, and the actual inflation rate is equal to the expected inflation rate.
Movement Along SRPC: An increase in aggregate demand moves the economy from Point A to a new point, Point B, which is up and to the left along the SRPC. At Point B, unemployment is lower than the NRU, and inflation is higher than expected.
Shift of SRPC: Over time, people adjust their inflationary expectations upward to match the new, higher inflation rate at Point B. This increase in expectations shifts the entire SRPC to the right. The new SRPC will intersect the LRPC at the higher inflation rate, establishing a new long-run equilibrium at Point C. The economy is back at the NRU, but with a higher permanent rate of inflation.
Step-by-Step Example
Scenario: The central bank pursues an unexpected expansionary monetary policy, causing aggregate demand to increase.
Step 1: Initial State & AD/AS Impact
The economy begins in long-run equilibrium at Point A on the Phillips curve graph, where unemployment is at the NRU (e.g., 5%) and inflation is stable and expected (e.g., 2%). The expansionary policy shifts the aggregate demand curve to the right, leading to a higher price level and higher real GDP.
Step 2: Short-Run Phillips Curve Impact
The increase in aggregate demand causes a movement along the existing SRPC. The economy moves from Point A to Point B. At Point B, the unemployment rate has fallen below the NRU (e.g., to 3%), and the inflation rate has risen above what was expected (e.g., to 4%). A short-run trade-off has been achieved: lower unemployment at the cost of higher inflation.
Step 3: Long-Run Adjustment
Because the actual inflation rate (4%) is now higher than the originally expected rate (2%), workers and firms revise their inflationary expectations upward. They begin to expect 4% inflation. This change in expectations shifts the entire SRPC to the right. As nominal wages rise to keep up with the higher expected inflation, the SRAS curve shifts left, and the economy moves back toward the LRPC. The economy settles at a new long-run equilibrium, Point C, where unemployment is back at the NRU (5%), but the inflation rate is now permanently higher at 4%. The short-run trade-off has vanished.
AP Exam Tips & Common Pitfalls
[FRQ Task]: You will frequently be asked to draw the Phillips curve model and show how an economic event (like a change in government spending, a supply shock, or a change in inflationary expectations) causes a movement along the SRPC or a shift of the SRPC.
[MCQ Task]: A common question asks you to distinguish between factors that cause a movement along the SRPC and factors that cause a shift of the SRPC. Remember that only changes in aggregate demand cause a movement along the curve.
[Common Pitfall ①]: Confusing movements along the SRPC with shifts of the SRPC.
- How to fix: Remember the cause-and-effect chain. A shift in aggregate demand moves the economy along the SRPC. A shift in short-run aggregate supply (due to supply shocks or changing expectations) shifts the entire SRPC.
[Common Pitfall ②]: Incorrectly drawing the LRPC with a slope.
- How to fix: The LRPC is always vertical. This represents the core concept that in the long run, the unemployment rate returns to its natural level regardless of the rate of inflation. Any trade-off is purely a short-run phenomenon.
Key Vocabulary
Short-Run Phillips Curve (SRPC): A curve showing the short-run inverse relationship between the inflation rate and the unemployment rate.
Long-Run Phillips Curve (LRPC): A vertical curve at the natural rate of unemployment, showing that there is no trade-off between inflation and unemployment in the long run.
Natural Rate of Unemployment (NRU): The rate of unemployment that exists when the economy is at its full-employment level of output, consisting of frictional and structural unemployment.
Inflationary Expectations: The rate of inflation that workers, businesses, and consumers anticipate for the future, which influences their economic decisions, especially regarding wages and prices.
Stagflation: A period of slow economic growth (stagnation) combined with high unemployment and rising prices (inflation), often caused by a negative supply shock.