Unemployment and Inflation Relationship The Philips Curve

The Phillips Curve 1958, New Zealand born economist, A.W. Phillips published the results of the relationship between the unemployment rate (u%) and the rate of inflation (π%) –Stable inverse relationship between the u% and the π%. – As u%↓, π%↑ ; and as u%↑, π%↓ The implication: –policy makers could exploit the trade-off and reduce u% at the cost of increased π%

The Phillips Curve (hypothetical example) π% u% PC 4% 2% 7%5% Note: Inflation Expectations are held constant

Trouble for the Phillips Curve In the 1970’s the United States experienced stagflation ( concurrent high u% & π%) Milton Friedman saw stagflation as disproof of the stable Phillips Curve. Instead of a trade-off between u% & π%, the natural u% was independent of the π%. This independent relationship is now referred to as the Long-Run Phillips Curve.

Trouble for the Phillips Curve π% u% PC 4% 2% 7%5% LRPC

The Long-Run Phillips Curve π% u% LRPC un%un% Note: Natural rate of unemployment is held constant

The Long-Run Phillips Curve (LRPC) Structural changes in the economy that affect u n will also cause the LRPC to shift. Increases in u n will shift LRPC  Decreases in u n will shift LRPC 

The Short-Run Phillips Curve (SRPC) π% u% SRPC 4% 2% 7%5% The key to understanding shifts in the Phillips curve is inflationary expectations!

The Short-Run Phillips Curve (SRPC) π% u% SRPC 4% 2% 7%5% SRPC 1

The Philip’s “Curl”

SRPC ( π^ %) LRPC π % uN%uN% A BC π1 %π1 % u%   SRPC ( π 1 ^ %) In the long-run, the inflation rate at B (π 1 % ) becomes the new expected inflation rate (π 1 ^ %), and the economy returns to the natural rate of unemployment (point C). Integrating the LRPC and SRPC π% u% Government enacts an expansionary policy to reduce the unemployment rate below its natural rate at point A. In the short-run (assuming the policy is successful) inflation occurs and unemployment decreases as the economy moves from A to B.

SRPC ( π^ %) LRPC π % uN%uN% A BC π1 %π1 % u%   SRPC ( π 1 ^ %) In the long-run, the inflation rate at B (π 1 % ) becomes the new expected inflation rate (π 1 ^ %), and the economy, once again, returns to the natural rate of unemployment (point C). Integrating the LRPC and SRPC π% u% Now assume that the government enacts a contractionary policy to reduce inflation from it’s current rate at point A In the short-run, assuming the policy is successful, disinflation occurs and unemployment increases as the economy moves from A to B.

Increase in AD = Up/left movement along SRPC— “Mirror Graphs” C↑, I G ↑, G↑ and/or X N ↑ AD GDP R PLu%π%up/left along SRPC  AD ↑  GDP R ↑ & PL↑  u%↓ & π%↑  up/left along SRPC GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    SRPC π u π% u%unun π 1π 1   ....

Decrease in AD = Down/right along SRPC C↓, I G ↓, G↓ and/or X N ↓ AD GDP R PLuπdown/right along SRPC  AD ↓  GDP R ↓ & PL↓  u%↑ &π%↓  down/right along SRPC GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    u% π% SRPC unun π u π1π1   ....

SRAS ↑ = SRPC ↓ Inflationary Expectations↓, Input Prices↓, Productivity↑, Business Taxes↓, and/or Deregulation SRAS GDP R PLu%π%SRPC  SRAS ↑  GDP R ↑ & PL↓  u%↓ & π%↓  SRPC↓ (Disinflation) GDP R PL AD SRAS LRAS YFYF P Y SRAS 1 P1P1    u% π% SRPC LRPC unun π u SRPC 1 π1π1   ....

SRAS ↓ = SRPC ↑ Inflationary Expectations↑, Input Prices↑, Productivity↓, Business Taxes↑, and/or Increased Regulation SRAS GDP R PLu%π%SRPC Stagflation  SRAS ↓  GDP R ↓ & PL↑  u%↑ & π%↑  SRPC ↑ (Stagflation) GDP R PL AD SRAS LRAS YFYF P Y1Y1 SRAS 1 P1P1    u% π% SRPC LRPC unun π u1u1 SRPC 1    π 1π 1....

Summary There is a short-run trade off between u% & π%. This is referred to as a short-run Phillips Curve (SRPC) In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC) The LRPC exists at the natural rate of unemployment (u n ). – u n ↑  LRPC ↑ – u n ↓  LRPC ↓ along ΔC, ΔI G, ΔG, and/or ΔX N = Δ AD = Δ along SRPC – AD ↑  GDP R ↑ & PL↑  u%↓ & π%↑  up/left along SRPC – AD ↓  GDP R ↓ & PL↓  u%↑ & π%↓  down/right along SRPC Δ SRPC Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC – SRAS ↑  GDP R ↑ & PL↓  u%↓ & π%↓  SRPC ↓ – SRAS ↓  GDP R ↓ & PL ↑  u%↑ & π%↑  SRPC ↑