The Short-Run Phillips Curve
Economics: IB Diploma, topic 2.3.12
The Phillips Curve
The Phillips Curve suggests that there is a tradeoff for policymakers between unemployment and inflation (i.e. both can't be low), based on observations made by economist A.W. Phillips in the 1950s.
Short-run Phillips curve (SRPC)
- The theory is that if unemployment went down, there would be an increase in inflationary pressure. And if unemployment went up, inflationary pressure would fall.
- If unemployment is high, there is lots of competition for vacancies and jobs. Firms can keep wages low and there is low cost-push inflationary pressure.
- If unemployment is low, the labor market is 'tight'. Firms need to offer much higher wages to get workers to come for them and existing workers have more power.
Policy implications
- The SRPC has policy implications, arguing that a government can aim for low unemployment or low inflation, but not both.
Stagflation
- This is an increase in both unemployment and inflation.
- A shift in the Phillips curve is caused by supply shocks and changes in inflationary expectations.
- Over long periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher.
Examples of stagflation
- The U.S. economy experienced the pattern of higher unemployment and inflation in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982.
- Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the mid-1970s oil crisis. The second is changes in people’s expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears.
When does the SRPC hold?
- We should interpret a downward-sloping Phillips curve as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).
Test yourself on The Short-Run Phillips Curve
The short-run Phillips curve implies that which of these government aims are NOT possible?
What do supply shocks and changes in inflationary expectations cause?