๐ The Short-Run Phillips Curve (SRPC)
The original Phillips curve: The Phillips curve shows an inverse relationship between unemployment and inflation in the short run. When unemployment falls, inflation tends to rise โ and vice versa.
- Discovered by A.W. Phillips (1958) โ originally showed the relationship between unemployment and wage inflation in the UK.
- The SRPC is a downward-sloping curve with inflation rate on the vertical axis and unemployment rate on the horizontal axis.
- Why the trade-off exists: Lower unemployment โ tighter labour market โ upward wage pressure โ higher production costs โ higher prices (cost-push inflation).
- Also: lower unemployment โ higher aggregate demand โ demand-pull inflation.
Policy implication
Keynesian economists argued the SRPC offered policymakers a menu of choices: they could accept higher inflation to achieve lower unemployment, or tolerate higher unemployment for lower inflation. This became the basis for demand-management policies in the 1960s.
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๐ The Long-Run Phillips Curve (LRPC)
Monetarist/New Classical view: Milton Friedman and Edmund Phelps argued there is no long-run trade-off between inflation and unemployment. The LRPC is vertical at the natural rate of unemployment (NRU).
The expectations-augmented Phillips curve
- Step 1: Government expands AD to reduce unemployment below the NRU โ moves along SRPCโ (lower U, higher ฯ).
- Step 2: Workers adjust inflation expectations upward โ demand higher wages.
- Step 3: Real wages return to original level โ unemployment returns to NRU but at HIGHER inflation โ SRPC shifts UP to SRPCโ.
- Step 4: If government tries again โ further shift to SRPCโ โ even higher inflation at the same NRU.
- Result: the LRPC is vertical โ you cannot permanently reduce unemployment below the NRU.
The stagflation challenge: The 1970s saw stagflation (high inflation + high unemployment), which contradicted the simple SRPC trade-off. This supported the monetarist view that the SRPC shifts when expectations change.
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โ๏ธ Policy Implications
Keynesian vs monetarist views
- Keynesian: The SRPC trade-off is exploitable in the short run. Fiscal/monetary expansion can reduce unemployment temporarily.
- Monetarist: Demand-side policies only create inflation in the long run. To permanently reduce unemployment, you must reduce the NRU through supply-side policies (education, training, labour market reforms).
- New Keynesian: The SRPC may be steep but not vertical in the LR โ there may be some persistent trade-off due to wage/price rigidities.
Shifting the LRPC
The LRPC shifts LEFT (NRU falls) if supply-side policies successfully reduce structural and frictional unemployment: better education, retraining programmes, labour market flexibility, reduced job search frictions.
In exam essays, always distinguish between the SR trade-off (exploitable through demand management) and the LR position (determined by structural factors). Show on a diagram how the SRPC shifts when expectations adjust.