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 ↑