Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Phillips Curve

In this section we take a closer look at the Phillips curve in the short and long runs, paying proper attention to the effect of changes in people’s expectations that we describe in the preceding section.

‘You can fool the people once’: Short-run Phillips curve (SRPC)

Figure 12-3 shows the negative relationship between inflation and unemployment in the short run. You can see that if inflation is equal to expected inflation, unemployment must also equal its natural rate.


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Figure 12-3: Short-run Phillipscurve (SRPC).

You can express this relationship mathematically as follows:

This equation says that inflation today ( ) is equal to expected inflation ( ) minus a term that depends on how far away actual unemployment (u_t) is from

its natural rate (u_n). The symbol represents how responsive inflation is to deviations in unemployment from its natural rate.


If actual unemployment is equal to the natural rate (u_t = u_n), inflation

must equal expected inflation ( ).

The fact that the SRPC must always go through ( ) has an important implication: changes in inflation expectations shift the Phillips curve. If people’s inflation expectations increase, the SRPC shifts up; equally, if their inflation expectations fall, the SRPC shifts down.

In Figure 12-4, initially people expected inflation to be , which means that the short-run trade-off between inflation and unemployment is represented by SRPC₀. If for some reason, however, people expect inflation to be higher, at , the Phillips curve shifts up to SRPC₁.

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Figure 12-4: How changes in inflation expectations affect SRPC.

This relationship ensures that if actual inflation is equal to expected inflation, unemployment is at its natural rate. Conversely, if for some reason people expect inflation to be lower, at , the Phillips curve shifts down to SRPC₂.


Notice that any policy makers who try to keep unemployment below the natural rate for a sustained period of time are in for a nasty shock. Sure, it may work the first time, stimulating the economy so inflation is higher than expected inflation and unemployment is lower than the natural rate. But doing so increases inflation expectations, causing the SRPC to shift up.

Now if the policy makers want to keep unemployment low, they must create even more inflation than they created last time. If this situation continues, quite soon inflation becomes explosive and uncontrollably high.

Thus building expectations into the Phillips curve makes clear that having low unemployment at the cost of high inflation in the long run is impossible.

‘Won’t get fooled again’: Long-run Phillips curve (LRPC)

In the long run (when prices are flexible), no trade-off exists between unemployment and inflation. You can’t persistently have unemployment away from its natural rate, because that would involve consistently fooling people by surprising them with ever higher inflation.

Therefore, basically, unemployment is going to be at its natural rate (u_n) whatever policy makers decide to do with inflation, which yields a completely vertical Phillips curve in the long run (see Figure 12-5).

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Figure 12-5: Long-run Phillipscurve (LRPC).

The LRPC suggests that policy makers shouldn’t get into the business of reducing unemployment by creating high inflation, because they just end up with high inflation and unemployment at its natural rate. Instead, they ought to decide on the level of inflation that they want (the consensus being that low, stable and positive balances the costs and benefits of inflation best) and target that figure. But they shouldn’t use expansionary monetary and fiscal policy to reduce unemployment in the long run.

If policy makers really want to reduce unemployment, they must focus on reducing the natural rate of unemployment itself. They can achieve this by using supply-side policies, such as having a more flexible labour market (as we discuss in Chapter 6). Figure 12-6 shows that a government successfully undertakes supply-side policies to reduce the natural rate of unemployment ( ), causing the LRPC to shift to the left ( ), which is the only way of reducing unemployment in the long run. Trying to reduce unemployment by increasing aggregate demand only leads to higher inflation without any fall in unemployment in the long run!

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Figure 12-6: Reducing the natural rate of unemployment.