Chapter Sixteen: Module Summary -- The Phillips Curve
- The Phillips Curve is a graph illustrating the inverse
relationship between inflation and unemployment. When inflation
rises, unemployment falls and vice versa.
- In the 1970s and 1980s the short-run relationship between inflation
and unemployment seemed to break down. Both inflation and unemployment
were high. Economists were able to salvage the Phillips Curve
by realizing that there is a difference between the short-run
and long-run relationship between inflation and unemployment.
- The long-run Phillips Curve is simply a vertical line
at the natural rate of unemployment, U*. In the long-run there
is no tradeoff between inflation and unemployment.
- The short-run relationship between inflation and unemployment
can be theoretically explained by shifts in the Aggregate Demand
curve. Such shifts result in higher prices and higher output,
which reduces unemployment. Any factor that shifts the Aggregate
Demand curve, moves the economy along the short-run Phillips Curve.
- In the long-run, the higher inflation leads to an increase
in inflation expectations. There is pressure for wages to rise,
which shifts the Aggregate Supply curve to the left. When inflation
expectations rise (fall), the Phillips Curve shifts upward (downward).
- The Phillips Curve can be expressed as:
= b(U* - U) +
where U* = the natural rate of unemployment, U = actual rate
of unemployment, and represents inflation expectations.
- The oil shocks of the 1970s led to a movement to the northeast
on the Phillips Curve. Policy makers were left with the difficult
choice of reducing the high inflation, or reducing the relatively
high levels of unemployment. They opted to reduce inflation.
In the short-term this led to even higher levels of unemployment.
But as inflation expectations fell, unemployment recovered.
- During much of the 1990s, the Phillips curve relationship again was suspiciously absent. Although unemployment declined substantially, inflation rates fell too. An increase in labor productivity is one possible reason for this odd behavior of the Phillips curve.