The Long-Run Phillips Curve
Economics: IB Diploma, topic 2.3.13
Long-Run Phillips Curve (LRPC)
After a period of stagflation in the 1970s, Monetarists, such as Milton Friedman, argued that the trade-off proposed by Phillips was only temporary, leading to the concept of the LRPC being introduced.
LRPC theory
- The LRPC was developed when the tradeoff between unemployment and inflation appeared to break down, as it did in the U.S. economy.
- The argument is that, in the long run, any attempts to reduce unemployment below its natural rate will cause rising inflation.
- If aggregate demand rises, more people have jobs, and firms hire more people. Workers receive higher nominal wages but they confuse the nominal wage increase for a real wage increase. This is called the money illusion.
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LRPC on a diagram
LRPC on a diagram
- A vertical long-run aggregate supply curve implies a vertical shape for the Phillips curve, indicating no long-run tradeoff between inflation and unemployment.
- The diagram above shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria at different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same.
- Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, in the diagram on the right, is a vertical line rising up from 5% unemployment, at any level of inflation.
Test yourself on The Long-Run Phillips Curve
Who are the higher costs passed on to?
On a diagram, what shape is the LRPC?