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
%Note: Natural rate of unemployment is held constant
The Long-Run Phillips Curve (LRPC)
• Structural changes in the economy that affect un will also cause the LRPC to shift.
• Increases in un will shift LRPC
• Decreases in un 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%
.. .
.
.
. ...
.. .
..
SRPC1
The Philip’s “Curl”
SRPC (π^ %)
LRPC
π %
uN%
A
B Cπ1 %
u%
SRPC (π1^ %)
In the long-run, the inflation rate at B (π1 %)becomes the new expected inflation rate (π1
^%), 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%
A
BCπ1 %
u%
SRPC (π1^ %)
In the long-run, the inflation rate at B (π1 %)becomes the new expected inflation rate (π1
^%), 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↑, IG↑, G↑ and/or XN↑ AD ↑ GDPR↑ & PL↑ u%↓ & π%↑ up/left along
SRPC
GDPR
PL
AD
SRASLRAS
YF
P
Y
AD1
P1
SRPC
π
u
π%
u%un
π 1
. .. .
Decrease in AD = Down/right along SRPC
C↓, IG↓, G↓ and/or XN↓ AD ↓ GDPR↓ & PL↓u%↑ &π%↓ down/right
along SRPC
GDPR
PL
AD
SRAS
LRAS
YF
P
Y
AD1
P1
u%
π%
SRPC
un
π
u
π1
. .. .
SRAS ↑ = SRPC ↓
Inflationary Expectations↓, Input Prices↓, Productivity↑, Business Taxes↓, and/or
Deregulation SRAS ↑ GDPR↑ & PL↓ u%↓ & π%↓ SRPC↓
(Disinflation)
GDPR
PL
AD
SRAS
LRAS
YF
P
Y
SRAS1
P1
u%
π%SRPC
LRPC
un
π
u
SRPC1
π1
. .. .
SRAS ↓ = SRPC ↑
Inflationary Expectations↑, Input Prices↑, Productivity↓, Business Taxes↑, and/or Increased
Regulation SRAS ↓ GDPR↓ & PL↑ u%↑ & π%↑ SRPC ↑
(Stagflation)
GDPR
PL
AD
SRAS
LRAS
YF
P
Y1
SRAS1
P1
u%
π%
SRPC
LRPC
un
π
u1
SRPC1
π 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 (un).– un ↑ LRPC ↑– un ↓ LRPC ↓
• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC– AD ↑ GDPR↑ & PL↑ u%↓ & π%↑ up/left along SRPC– AD ↓ GDPR↓ & PL↓ u%↑ & π%↓ down/right along SRPC
• Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC – SRAS ↑ GDPR↑ & PL↓ u%↓ & π%↓ SRPC ↓– SRAS ↓ GDPR↓ & PL ↑ u%↑ & π%↑ SRPC ↑