1 Inflation and Unemployment: The Phillips Curve Inflation and Unemployment: The Phillips Curve

Phillips Curve Intro Khan Academy Tutorials NgU4 NgU4

Output Gap and the Unemployment Rate Changes in aggregate output around the long-run trend of potential output correspond to changes in the unemployment rate around the natural rate. When actual aggregate output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment. (around 5% usually in the US) When there is an inflationary gap, the unemployment rate is below the natural rate. When there is a recessionary gap, the unemployment rate is above the natural rate.

Phillips Curve Created by economist A.W. Phillips in 1958 He studied the relationship between wage inflation and unemployment rate Phillips concluded that periods of wage inflation were associated with periods of high unemployment Now 2 types of Phillips Curves: short-run Phillips curve (SRPC) and long-run Phillips curve (LRPC)

The Short-Run Phillips Curve Expansionary policies lead to a lower unemployment rate but higher inflation. Contractionary policies lead to lower inflation but a higher unemployment rate. Short Run Phillips Curve: There is a short-run trade-off between unemployment and inflation.

The negative short-run relationship between the unemployment rate and the inflation rate

Point A – high inflation and very low unemployment Point B – both inflation and unemployment about 3% Point C – very low inflation and high unemployment Unemployment greater than 8% has deflation (negative inflation)

Changes in aggregate demand will affect an economy’s short-run level of output, but in the long-run, output always returns to the full- employment level (natural rate of employment) So, in the long run, there is no trade-off between inflation and unemployment Regardless of whether AD increases or decreases in the short-run, in the long-run an economy will always produce at is full- employment level of output.

Just like there is a long-run aggregate supply curve that is vertical at the full-employment level of output, there is a long-run Phillips Curve which is vertical at the natural rate of employment Since output will always return to is full- employment level once wages and prices have adjusted in the long-run, unemployment will always return to its natural rate in the long run.

Long-Run Phillips Curve In the graph above, it can be seen that regardless of the level of aggregate demand in the economy, output and unemployment will return to the natural rate of unemployment in the long run.

Long-Run Phillips Curve LRAS and LRPC are mirror images Whatever shifts LRAS to the right, will shift the LRPC to the left.

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