Introduction: The Great Trade-Off
Welcome to one of the most important visual tools in macroeconomics! In previous units, we looked at how the economy fluctuates between booms and recessions. Now, we are going to look at the relationship between two of our biggest "enemies" in macro: inflation and unemployment. The Phillips Curve illustrates the trade-off between these two variables in the short run and explains why that trade-off disappears in the long run.
1. The Short-Run Phillips Curve (SRPC)
The Short-Run Phillips Curve (SRPC) represents the inverse (negative) relationship between the inflation rate and the unemployment rate. In simple terms: when inflation is high, unemployment tends to be low, and vice versa.
Graphing the SRPC
On an AP Macroeconomics graph for the Phillips Curve:
• The vertical axis is the Inflation Rate.
• The horizontal axis is the Unemployment Rate.
• The SRPC is a downward-sloping curve.
Think of it like a seesaw: When one side (inflation) goes up, the other side (unemployment) usually goes down. This happens because when the economy is "hot" (high demand), businesses hire more workers (lower unemployment), but the high demand also pushes prices up (higher inflation).
Movement Along the SRPC vs. Shifting the SRPC
This is a critical distinction for the AP Exam. Don't worry if it seems confusing; just remember what causes the change in the AD-AS model (from Unit 3):
A. Movement ALONG the SRPC: This is caused by a shift in Aggregate Demand (AD).
• If AD increases (shifts right), the economy moves up and to the left along the SRPC (higher inflation, lower unemployment).
• If AD decreases (shifts left), the economy moves down and to the right along the SRPC (lower inflation, higher unemployment).
B. Shifting the SRPC: This is caused by a shift in Short-Run Aggregate Supply (SRAS).
• If SRAS increases (shifts right), the SRPC shifts left/down (a "double win": lower inflation and lower unemployment).
• If SRAS decreases (shifts left, also known as Stagflation), the SRPC shifts right/up (a "double loss": higher inflation and higher unemployment).
Memory Trick: The SRPC always shifts in the opposite direction of the SRAS curve. If SRAS goes Right, SRPC goes Left.
2. The Long-Run Phillips Curve (LRPC)
In the long run, there is no trade-off between inflation and unemployment. This is because the economy eventually self-adjusts to its "natural state" regardless of the price level.
Key Characteristics of the LRPC:
• The LRPC is a vertical line.
• It is located at the Natural Rate of Unemployment (NRU).
• The NRU is the same as the Full-Employment level of output shown on the LRAS curve.
• Any point on the LRPC represents an economy in long-run equilibrium.
Key Takeaway: While the government might try to lower unemployment by creating inflation in the short run, in the long run, the unemployment rate will always return to the \( NRU \).
3. Connecting AD-AS to the Phillips Curve
The AP Exam loves to ask you to show a change on both the AD-AS model and the Phillips Curve model simultaneously. Here is the "cheat sheet" for how they mirror each other:
Scenario 1: Inflationary Gap
• AD-AS: Equilibrium is to the right of the LRAS.
• Phillips Curve: The point is to the left of the LRPC (lower unemployment than the \( NRU \)).
Scenario 2: Recessionary Gap
• AD-AS: Equilibrium is to the left of the LRAS.
• Phillips Curve: The point is to the right of the LRPC (higher unemployment than the \( NRU \)).
Scenario 3: Long-Run Equilibrium
• AD-AS: AD, SRAS, and LRAS all intersect.
• Phillips Curve: The SRPC and LRPC intersect at the current inflation rate.
4. Inflationary Expectations
Why does the SRPC shift? One major reason is inflationary expectations. If workers and businesses expect inflation to be higher in the future, they will behave differently today.
• If expected inflation increases, workers demand higher nominal wages to keep up. This increases production costs (shifting SRAS left), which shifts the SRPC to the right.
• If expected inflation decreases, production costs fall (shifting SRAS right), which shifts the SRPC to the left.
Quick Review Box:
• Movement along SRPC = Change in Aggregate Demand.
• Shift of SRPC = Change in SRAS or change in Inflationary Expectations.
• Shift of LRPC = Change in the Natural Rate of Unemployment (e.g., changes in labor force characteristics or technology).
5. Common Mistakes to Avoid
1. Labeling Axes Incorrectly: Do not label the Phillips Curve axes as "Price Level" and "Real GDP." Those belong to the AD-AS model. Use Inflation Rate and Unemployment Rate.
2. Misidentifying the Shift: Remember that an AD shift is a point moving along the curve. If the question says AD increased, do not move the SRPC line; just move the dot on the line!
3. The "Opposite" Rule: When drawing a shift, remember that a "good" thing for the economy (SRAS shifting right) results in the SRPC shifting "left" (toward the origin), which represents lower inflation and lower unemployment.
Did you know? The Phillips Curve is named after A.W. Phillips, who originally noticed this relationship by studying nearly 100 years of data on wages and unemployment in the United Kingdom!
Key Summary for the Exam:
The Short-Run Phillips Curve shows the trade-off: \( \text{Higher Inflation} = \text{Lower Unemployment} \). The Long-Run Phillips Curve is vertical at the Natural Rate of Unemployment, showing that in the long run, monetary and fiscal policy can influence inflation but cannot keep unemployment below its natural rate forever.