Philips curve

Another way to study Inflation cycles is to look at the trade-off between unemployment and inflation.

What happens to the unemployment rate when inflation is high? What if inflation is low? To understand this, we look at Philips Curve.

There are two-time frames of Philips Curves:

1. Short-Run Philips Curve
2. Long-Run Philips Curve

Short-Run Philips Curve

Short-Run Philips Curve: is the relationship between unemployment and inflation, while holding expected inflation and the natural unemployment rate constant.

The following graph shows the short-run Philips Curve:


Notice that

1. Curve is U-Shaped.
2. At point A, expected inflation rate is 3%, unemployment rate is 3%
3. Aggregate demand $\, \uparrow \,$, then unemployment $\, \downarrow \,$ & inflation $\, \uparrow \,$. This is a movement up along the curve.
4. Aggregate demand $\, \downarrow \,$, then unemployment $\, \uparrow \,$ & inflation $\, \downarrow \,$. This is a movement up along the curve.

Long-Run Philips Curve

Long-Run Philips Curve: is the relationship between inflation and unemployment when the expected inflation rate = actual inflation rate.

The following graph shows the long-run Philips Curve:


Notice that

1. The curve is a vertical line
2. The curve is vertical at the natural unemployment rate
3. Any expected inflation rate is possible at the natural unemployment rate

Short-Run, Long-Run Philips Curve & Its Changes

Now that we learned about short-run Philips curve, and long-run Philips curves, we can put them together in a graph.


The short-run Philips curve and the long-run Philips curve intersects at the expected inflation rate.

Changes to the Expected Inflation Rate

When the expected inflation rate increases or decreases, it changes the Philips curves.

Case 1: Suppose the expected inflation rate increases.

The long-run Philips curve does not change, but the short-run Philips curves shifts right.


Case 2: Suppose the expected inflation rate decreases.

The long-run Philips curve does not change, but the short-run Philips curves shifts downward.


Changes to the Natural Unemployment Rate

When the natural rate of unemployment changes, it can also affect the Philips curves.

Case 1: Suppose the natural rate of unemployment increases.

Then the long-run Philips curve shifts rightward, and the short-run Philips curve also shifts right.


We see that there is no effect to the expected inflation rate because it is constant.

Case 2: Suppose the natural rate of unemployment decreases.

Then the long-run Philips curve shifts leftward, and the short-run Philips curve shifts down.


Once again, there are no changes to the expected inflation rate, but the unemployment rate has decreased.