The Phillips curve
The Phillips curve is our final concept for the short run and our first concept for the long run. It has the inflation rate is on the y-axis and the unemployment rate is on the x-axis.
It can be helpful to view this as nothing more than a transformation of the - model, with a focus on the labor market directly instead of real GDP. Again we will see that in the short run there is a trade-off between prices and economic activity, while in the long run there is not.
Short run Phillips curve
We begin with a short run equilibrium in the - model. From this, if shifts to the right, and both rise. Another way to view these changes is as an increase in inflation and a reduction in the unemployment rate, a movement from point to point in each graph.
If shifts left, the opposite occurs. is lower, which is the same as lowering inflation, and is lower, which is the same as raising the unemployment rate. This is a movement from point to point in each graph. Changes in the are always movements along a single short run Phillips curve.
One lesson from the short run - model was that there is a trade-off between the price level and production. What the does is highlight that there is also a tradeoff between inflation and unemployment in the short run. This trade-off exists for the same reason that is upward sloping, sticky prices.
Shifters
Because the mirrors the , one might guess that the shifters are the same and that is completely correct. Be careful that while the shifts are the same conceptually, they are in the opposite direction as shifts. For that reason, it can be slightly more intuitive for explanations to refer to shifts in the short run Phillips curve as up and down instead of left and right.
| Shifter | (up) | (down) |
|---|---|---|
| Supply shock | Negative | Positive |
| Expected inflation | Higher | Lower |
Higher expected inflation or a negative supply shock leads to higher inflation for every level of unemployment (output). Either of these shift left and the up (right).
Lower expected inflation or a positive supply shock have the opposite effect. Lower inflation for every level of unemployment (output). So these shift right and the down (left).
The long run
Just as the short run Phillips curve is connected to short run aggregate supply, the long run Phillips curve is linked to long run aggregate supply.
Just as with aggregate supply, the long run version is vertical. Recall that the curve is vertical at , which is the level of output associated with the natural rate of unemployment, . The long run Phillips curve () is vertical at .
Again the trade-off of the short run disappears in the long run. This is because in the long run wages fully adjust, so inflation must be equal to expected inflation and output must return to the full employment level.
The short run Phillips curve crosses the long run Phillips curve at the expected rate of inflation. This is what is different than the aggregate supply and aggregate demand model. There we had no specific price level where the short and long run curves crossed.
Shifters
Shifters of the are more limited than those of the curve. The only shifters are factors that change the natural rate of unemployment. So anything that adjusts the level of frictional or structural unemployment in the economy will also shift the long run Phillips curve.
| Shifter | ||
|---|---|---|
| Demographic changes | Negative | Positive |
| Labor market conditions | Weaker | Stronger |
A demographic change may stem from differences in the size of generations, immigration, education and gender. An ongoing story is the retirement of the baby boomer generation. It is larger than the cohorts that follow, so as they begin to retire that will lead to the labor force shrinking. This may cause shortages of workers with education and training in specific sectors, such as healthcare or software engineering.
Globalization and expanded trade can also lead to shifts in the location of production, leaving unemployed workers who may have difficulty transitioning to the jobs that remain available.
Labor market conditions cover items mentioned earlier, for example laws regulating hours and working conditions. It also includes technological innovations. The advent of the internet and job websites could be thought to reduce frictional unemployment, making the process of changing jobs faster.
Transition from short run to long run
In the - model, prices adjust causing a shift in which returns output to potential GDP. In the Phillips curve, the adjustment comes from changes in expected inflation.
We mostly do not concern ourselves with how inflation expectations are formed. The sequence of events is what is likely to show up at least once on the test. In the Phillips curve story, expectations of inflation align with actual inflation and shift the short run curve to intersect the long run curve at that inflation rate. So all we assume is that in the long run inflation expectations match actual inflation.
This is almost perfectly identical to the long run adjustment in the - model. There price adjustments shift the curve so that , and all cross at . In the Phillips curve, if we are not in a long run equilibrium then expected inflation changes to match actual inflation and the shifts to cross the at the natural rate of unemployment.
The graph shows the example of an inflationary gap. This moves the economy up the , raising inflation to and lowers unemployment. When expectations fully adjust to the new level of inflation, there is a shift to a new and the economy returns to full employment at .