KEY POINTS
- The long-run Phillips curve is a vertical line at the natural rate of unemployment, but the short-runPhillips curve is roughly L-shaped.
- The inverse relationship shown by the short-run Phillips curve only exists in the short-run; there is notrade-off between inflation and unemployment in the long run.
- Economic events of the 1970's disproved the idea of a permanently stable trade-off between unemployment and inflation.
TERM
- Phillips curve
A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.
FULL TEXT
The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables . As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.
Short-Run Phillips Curve
Consider the example shown in . When the unemployment rate is 2%, the corresponding inflation rate is 10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when unemployment increases to 6%, the inflation rate drops to 2%.
Short-Run Phillips Curve
Historical application
During the 1960's, the Phillips curve rose to prominence because it seemed to accurately depict real-world macroeconomics. However, the stagflation of the 1970's shattered any illusions that the Phillips curve was a stable and predictable policy tool. Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and inflation in the short-run. Given a stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output increases, unemployment decreases. With more people employed in the workforce, spending within the economy increases, and demand-pull inflation occurs, raising price levels.
Therefore, the short-run Phillips curve illustrates a real, inverse correlation between inflation and unemployment, but this relationship can only exist in the short run. The idea of a stable trade-off between inflation and unemployment in the long run has been disproved by economic history.