The short-run Phillips curve and the trade-off between inflation and unemployment

The short-run Phillips curve illustrates a relationship between inflation and unemployment in an economy. It suggests that there is a trade-off, where lower inflation is associated with higher unemployment, and higher inflation with lower unemployment.

Origins and key features

A.W. Phillips observed this pattern by analysing historical data on inflation and unemployment. The curve slopes downwards, showing that as inflation decreases, unemployment tends to increase, and the reverse also holds.

Governments can influence this trade-off by boosting aggregate demand to lower unemployment, though this often leads to higher inflation as a consequence.

Connection to Keynesian economics

Keynesian economists support the idea of this trade-off. The short-run Phillips curve aligns with the curved portion of a Keynesian long-run aggregate supply (LRAS) curve.

Stages in the Keynesian LRAS curve related to the Phillips curve:

• Low output levels - Here, unemployment is high, and workers accept jobs even at lower wages. Output can rise without much impact on inflation.
• Intermediate output levels - As output grows and unemployment drops, prices begin to rise, leading to increased inflation.

Adaptive expectations and their impact on inflation

Adaptive expectations refer to the way people form predictions about the future based on past experiences. This concept helps explain how inflation can persist in an economy.

How adaptive expectations work

If inflation is high in the current period, individuals such as workers and firms will anticipate similar levels in the future. This anticipation can cause high inflation to become embedded, making it difficult to reduce without significant economic adjustments.

Consequences of adaptive expectations

When expectations of inflation rise, wage demands increase accordingly. Firms may then pass on these higher costs through price increases, reinforcing the cycle of inflation.

The long-run Phillips curve and the natural rate of unemployment

The long-run Phillips curve addresses the limitations of the short-run model by incorporating expectations of inflation. It argues that there is no permanent trade-off between inflation and unemployment over the long term.

Key features

Monetarist economists developed this vertical curve, positioned at the natural rate of unemployment (NRU). The NRU represents the level of unemployment when the economy is in equilibrium, with no cyclical factors influencing it.

No matter the inflation rate, unemployment will eventually return to the NRU.

Process of adjustment in the long run

Consider an economy at the NRU with 0% inflation, where economic agents expect inflation to remain at zero percent:

• If aggregate demand rises, unemployment falls below the NRU, prompting higher wage demands and rising inflation.
• Agents then adjust their expectations to the new higher inflation rate, leading to further wage increases.
• Firms respond by hiring fewer workers due to higher costs, pushing unemployment back to the NRU.
• This causes the short-run Phillips curve to shift rightwards, embedding the higher inflation rate.

Monetarists argue that boosting aggregate demand only raises inflation temporarily, with no lasting effect on unemployment, which reverts to the NRU.

Historical context and criticisms of the Phillips curve

The Phillips curve has evolved through historical use and challenges, highlighting its strengths and weaknesses in economic analysis.

Historical use

In the 1950s and 1960s, governments applied the curve to balance inflation and unemployment, adjusting policies to manage the trade-off.

Breakdown in the 1970s

The relationship faltered during this period, leading to stagflation—a combination of high inflation, high unemployment, and low economic growth. Monetarists criticised the short-run Phillips curve for ignoring expected inflation, which contributed to this breakdown.

Modern criticisms

Some economists doubt the existence of a reliable short-run Phillips curve relationship. Supply-side policies, such as improving education or labour market flexibility, can potentially allow low unemployment and low inflation to coexist without a trade-off.

Modern applications and policy implications

Today, the Phillips curve is mainly applied in short-run economic policy, with governments focusing on managing inflation expectations to avoid persistent rises.

Policy approaches to prevent embedded inflation

Governments implement measures to stop inflation from increasing continuously. For example, in the UK, the Bank of England targets an inflation rate of around 2%. This stable target helps shape economic agents' expectations, keeping wage and price demands aligned with low inflation.

Implications for economic management

By maintaining consistent inflation targets, policies ensure that short-run shifts do not lead to long-term embedded inflation, supporting stable unemployment at the NRU.