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.

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