What is the difference between the short run Phillips curve and the long run Phillips curve?

The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables . As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.

The short-run Phillips curve shows that in the short-term there is a tradeoff between inflation and unemployment. Contrast it with the long-run Phillips curve (in red), which shows that over the long term, unemployment rate stays more or less steady regardless of inflation rate.

Consider the example shown in . When the unemployment rate is 2%, the corresponding inflation rate is 10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when unemployment increases to 6%, the inflation rate drops to 2%.

Historical application

During the 1960's, the Phillips curve rose to prominence because it seemed to accurately depict real-world macroeconomics. However, the stagflation of the 1970's shattered any illusions that the Phillips curve was a stable and predictable policy tool. Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and unemployment in the short-run. Given a stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output increases, unemployment decreases. With more people employed in the workforce, spending within the economy increases, and demand-pull inflation occurs, raising price levels.

Therefore, the short-run Phillips curve illustrates a real, inverse correlation between inflation and unemployment, but this relationship can only exist in the short run. The idea of a stable trade-off between inflation and unemployment in the long run has been disproved by economic history.

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The short-run Phillips curve is said to shift because of workers' future inflation expectations. Yet, how are those expectations formed? There are two theories that explain how individuals predict future events.

Real versus Nominal Quantities

To fully appreciate theories of expectations, it is helpful to review the difference between real and nominal concepts. Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for inflation. To make the distinction clearer, consider this example. Suppose you are opening a savings account at a bank that promises a 5% interest rate. This is the nominal, or stated, interest rate. However, suppose inflation is at 3%. The real interest rate would only be 2% (the nominal 5% minus 3% to adjust for inflation).

The difference between real and nominal extends beyond interest rates. In an earlier atom, the difference between real GDP and nominal GDP was discussed. The distinction also applies to wages, income, and exchange rates, among other values.

Adaptive Expectations

The theory of adaptive expectations states that individuals will form future expectations based on past events. For example, if inflation was lower than expected in the past, individuals will change their expectations and anticipate future inflation to be lower than expected.

To connect this to the Phillips curve, consider . Assume the economy starts at point A at the natural rate of unemployment with an initial inflation rate of 2%, which has been constant for the past few years. Accordingly, because of the adaptive expectations theory, workers will expect the 2% inflation rate to continue, so they will incorporate this expected increase into future labor bargaining agreements. This way, their nominal wages will keep up with inflation, and their real wages will stay the same.

According to adaptive expectations theory, policies designed to lower unemployment will move the economy from point A through point B, a transition period when unemployment is temporarily lowered at the cost of higher inflation. However, eventually, the economy will move back to the natural rate of unemployment at point C, which produces a net effect of only increasing the inflation rate.According to rational expectations theory, policies designed to lower unemployment will move the economy directly from point A to point C. The transition at point B does not exist as workers are able to anticipate increased inflation and adjust their wage demands accordingly.

Now assume that the government wants to lower the unemployment rate. To do so, it engages in expansionary economic activities and increases aggregate demand. As aggregate demand increases, inflation increases. Because of the higher inflation, the real wages workers receive have decreased. For example, assume each worker receives $100, plus the 2% inflation adjustment. Each worker will make $102 in nominal wages, but $100 in real wages. Now, if the inflation level has risen to 6%. Workers will make $102 in nominal wages, but this is only $96.23 in real wages.

Although the workers' real purchasing power declines, employers are now able to hire labor for a cheaper real cost. Consequently, employers hire more workers to produce more output, lowering the unemployment rate and increasing real GDP. On , the economy moves from point A to point B.

However, workers eventually realize that inflation has grown faster than expected, their nominal wages have not kept pace, and their real wages have been diminished. They demand a 4% increase in wages to increase their real purchasing power to previous levels, which raises labor costs for employers. As labor costs increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the economy moves from point B to point C.

This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself to the natural rate of unemployment with higher inflation.

Rational Expectations

The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will be very close to the market equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will take this past information and current information, such as the current inflation rate and current economic policies, to predict future inflation rates.

As an example of how this applies to the Phillips curve, consider again. Assume the economy starts at point A, with an initial inflation rate of 2% and the natural rate of unemployment. However, under rational expectations theory, workers are intelligent and fully aware of past and present economic variables and change their expectations accordingly. They will be able to anticipate increases in aggregate demand and the accompanying increases in inflation. As such, they will raise their nominal wage demands to match the forecasted inflation, and they will not have an adjustment period when their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point A to point C, without transitioning to point B.

In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically undermined by rational workers. They can act rationally to protect their interests, which cancels out the intended economic policy effects. Efforts to lower unemployment only raise inflation.

If you're like me, you probably think unemployment is not all that hard to fix. You just put policies in place to create more jobs, and problem solved. Right?

But what if I also told you that many economists don't believe there is anything policymakers can do to affect the long-term unemployment rate? Moreover, that there is, in fact, a natural long-term rate of unemployment that can't be affected very much at all.

When I first heard this, I had a hard time believing it, but as it turns out, it's actually true.

Read on to find out why this is.

The Phillips curve model is used to represent the relationship between inflation and unemployment and to illustrate how macroeconomic shocks affect inflation and unemployment.

In order to understand the Long-Run Phillips Curve, we must first understand the Short-Run Phillips Curve.

In its basic form, the Short-Run Phillips Curve states that there is an inverse relationship between inflation and unemployment. In other words, when there is high inflation, there is low unemployment and vice versa.

While the definition is simple to explain, it takes a bit more knowledge to understand it. In particular, it's necessary to also understand monetary policy, fiscal policy, aggregate demand, and aggregate supply.

Since this explanation focuses on the Long-Run Phillips curve, we won't spend much time on each of these concepts, but we will briefly touch on them.

Aggregate Demand

In its simplest form, Aggregate Demand is the total amount of demand for all goods and services available in an economy.

Aggregate Demand is composed of demand from households, firms, governments, and foreign buyers with respect to net exports. The formula for Aggregate Demand is C + I + G + (X - M), where C is consumer demand, I is investment demand, G is government demand, X is exports, and M is imports.

Aggregate Supply

Aggregate Supply, or more specifically Short-Run Aggregate Supply (SRAS), describes the total quantity of goods and services that firms are willing to produce and sell at any given price level.

Alternately stated, the SRAS Curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the short run when many production costs are assumed to be fixed. As a result, the Short-Run Aggregate Supply Curve slopes upwards.

In the short-run, aggregate price levels and output quantities adjust to bring aggregate demand and aggregate supply into short-run equilibrium.

Figure 1 illustrates equilibrium in an economy in terms of aggregate price levels and aggregate output.

Figure 1. Aggregate Demand and Aggregate Supply Equilibrium, StudySmarter Originals

Monetary Policy

Monetary policy is the management of the money supply and interest rates by central banks to influence a country's output or GDP, employment, and aggregate prices, or inflation.

Figure 2 illustrates the impact that expansionary monetary policy has on economic output and aggregate prices.

For example, when a central bank increases an economy's money supply, this results in a lowering of that economy's interest rates.

Generally speaking, when interest rates fall, both consumer and investment spending increase because it becomes cheaper to take out loans. As a result of the increased consumer and investment spending, Aggregate Demand shifts to the right, with the end result being increased economic output, or (GDP), and higher price levels.

Figure 2. Expansionary Monetary Policy Shift in Aggregate Demand, StudySmarter Originals

By definition, fiscal policy is the use of government purchases of goods and services, as well as taxation levels to affect an economy.

Since Aggregate Demand includes government spending (G), a change in G will directly affect the Aggregate Demand curve. Similarly, when a government changes taxation levels, this directly affects the amount of post-tax money available to households (Consumer spending) and firms (Investment spending), thereby also directly affecting the Aggregate Demand curve.

Consider Figure 3 below, where fiscal policy is used to induce a rightward shift in Aggregate Demand either through increased spending, or decreased levels of taxation.

You'll notice Figure 3 looks very similar to Figure 2, because it is, although due to different causalities.

Figure 3. Expansionary Fiscal Policy Shift in Aggregate Demand, StudySmarter Originals

Long-Run Philips Curve Graph

We have now completed our quick review of how monetary and fiscal policy affect prices and output so we are now ready to discuss the Long-Run Phillips Curve Graph.

It turns out that, in order to arrive at the Long-Run Phillips Curve Graph, it is necessary to understand the Short-Run Phillips Curve Graph, so we will start there.

By definition, the Short-Run Phillips Curve postulates that there is a distinct correlation between inflation and unemployment. More specifically, there is a negative correlation between inflation and unemployment levels in the short-run, resulting from monetary and fiscal policy. Figure 4 helps illustrate the mechanism behind this correlation.

Figure 4. Expansionary Policy and theShort-Run Phillips Curve, StudySmarter Originals

As you can see, regardless of whether the expansionary policy is brought about by Fiscal or Monetary policy, the Short-Run Phillips Curve slopes downward to illustrate the trade-off between inflation and unemployment in an economy.

In order to understand the Long-Run Phillips Curve, we need to understand shifts in the Short-Run Phillips Curve.

In economics, any graphical representation of how two variables interact can only illustrate the two variables in question (the endogenous variables). Since the Short-Run Phillips Curve illustrates the relationship between inflation and unemployment, a shift in the short-run Phillips curve must come about from the effects of an outside variable (an exogenous variable).

For the purposes of understanding the long-run Phillips curve, the exogenous variable required is Aggregate Supply, and more specifically shifts in Aggregate Supply.

Figure 5 illustrates the impact on an economy of a leftward shift in Aggregate Supply.

A leftward shift in Aggregate Supply is the result of firms wanting to produce less output at the existing aggregate price level. Common causes of leftward shifts in Aggregate Supply are negative supply shocks, which make the cost of production higher.

A supply shock is an event that shifts the Short-Run Aggregate Supply Curve, such as a change in commodity prices, nominal wages, productivity, and expected inflation.

Figure 5. Long-Run Phillips Curve Shift in Aggregate Supply, StudySmarter Originals

Figure 5 illustrates a negative, or leftward supply shock, where an increase in the costs of factors of production causes producers to have to reduce their output levels at the given aggregate price level. This is shown in the shift from Q0 to Q', and points A and B'. In order for equilibrium to be re-established therefore, prices must increase from P0 to P1 and an equilibrium level of output of Q1, at point B.

As you can see, a negative supply shock results in both higher prices AND higher unemployment due to reduced output.

As mentioned, one of the causes of a supply shock is expected inflation, which is the inflation rate that workers expect to experience. When workers expect a certain level of inflation to persist, they will require their wages to rise correspondingly so that their buying power doesn't diminish. Therefore, workers build increases in their wages, sometimes called cost of living adjustments (COLA), into their labor contracts, thereby increasing producers' input costs.

Figure 6 illustrates the changes in output, inflation, and unemployment that come about due to a supply shock such as expected inflation.

Figure 6. Supply Shock Effect on Short-Run Phillips Curve, StudySmarter Originals

As illustrated in Figure 6, the new equilibrium point C results in higher prices and lower output resulting from an expected inflation supply shock and therefore requires the short-run Phillips curve to shift upward to illustrate that the economy is now in a state of higher inflation AND higher unemployment.

This is not an ideal situation for an economy to find itself in, and it is called stagflation.

Stagflation is an economic condition where persistently high inflation and high unemployment exist simultaneously.

Now that we've covered how supply shocks and expected inflation can cause shifts in aggregate supply, we have the framework for understanding the Long-Run Phillips curve.

Long-Run Phillips Curve Definition

The key difference between the Short-Run and Long-Run Phillips Curves is inextricably tied to expected inflation and supply shocks.

To understand how expected inflation affects the Long-Run Phillips curve let's look at what happens over the long ru when an expansionary policy is put into effect.

Expansionary Policy

Let's consider Figure 7, and let's assume that the current level of inflation is P0 and the unemployment rate is 9%. Let's also assume that the expected level of inflation is the actual level of inflation at P0.

Figure 7. Long-Run Phillips Curve and Expansionary Policy, StudySmarter Originals

Now let's assume there's an election coming up, and the incumbent government wants to show that it's doing a good job and decides to use fiscal policy to lower unemployment by one percentage point to 8%.

The incumbent government will apply an expansionary policy, shifting Aggregate Demand to the right, and increasing economic output from Q0 to Q1. We can see that, while the government was successful in decreasing unemployment, it has also increased aggregate price levels from P0 to P1. Since you are now well-versed in the Short-Run Phillips Curve, you know that this will cause a movement along the curve from point A to point B, with unemployment now at 8%, and inflation at P1.

Success right?

Not quite.

You see, while the government successfully increased economic output, and therefore lowered unemployment, in doing so they also increased inflation. Recall that households and workers do account for expected inflation, and now that the actual inflation rate has deviated from its previous rate, workers will endeavor to get wage increases to ensure their purchasing power isn't diminished by asking for COLA wage increases. We know this by another term - a supply shock.

Figure 8 illustrates the effect of the new level of expected inflation on the Short-Run Phillips curve.

Figure 8. Long-Run Phillips Curve and Expected Inflation, StudySmarter Originals

Since we know that a supply shock will shift aggregate supply to the left, and therefore also shifts the Short-Run Phillips Curve up, we can see by examining Figure 8 that the net effect is a return to 9% unemployment, but at a higher rate of inflation at P2, Q1 and Point C.

If the government persists in trying to lower unemployment rates in anticipation of the upcoming election and re-applies fiscal policy and increases Aggregate Demand once again, they will successfully lower the unemployment rate again to 8%, but at even higher aggregate prices.

Figure 9 illustrates this result by shifting Aggregate Demand once again and shifting the equilibrium to points D, P3 and Q1.

At this point, you know what will happen next. Since expected inflation is higher yet again, a COLA supply shock will re-establish equilibrium at point E with output at Q0 and prices at P4.

As it turns out, the government's efforts to move away from the initial equilibrium unemployment rate of 9% are futile because the Long-Run Phillips curve is perfectly vertical at this non-accelerating inflation rate of unemployment (NAIRU).

Put another way, the only long-run equilibrium available to governments and central banks is at the NAIRU, which is where the Long-Run Phillips curve can be found.

Figure 9. Long-Run Phillips Curve, StudySmarter Originals

The simplest way to think about the Long-Run Phillips Curve, therefore, is to understand that the Long-Run Phillips Curve shows the relationship between unemployment and inflation when expected inflation is also being accounted for over the long term.

As you can see, there are many changes going on in scenarios like the one depicted in Figure 9. You would be right to assume that these changes take time. As a result, it's important to have a naming convention for these periods of adjustment.

As a result, whenever an economy is experiencing a period where unemployment is to the left of the Long-Run Phillips Curve and the NAIRU, these are called inflationary gaps, while periods where unemployment is to the right of the Long-Run Phillips Curve and the NAIRU, are called recessionary gaps,

Points to the left of the Long-Run Phillips Curve equilibrium represent inflationary gaps, while points to the right of the Long-Run Phillips Curve equilibrium represent recessionary gaps.

In order to think about what might cause a shift in the Long-Run Phillips Curve, it's helpful to think about what might cause a shift in the NAIRU, also known as the Natural Rate of Unemployment.

The StudySmarter explanation for the Natural Rate of Unemployment is an excellent resource to help understand this topic, but in very simple terms, factors that change the Long-Run Phillips Curve, and correspondingly the Natural Rate of Unemployment include:

• Changes in labor force characteristics such as productivity improvements;
• Impacts of labor force institutions such as unions;
• Changes in government policies such as improved employee training, easier job relocation, and changes to the minimum wage.

There is some debate as to the nature of the Long-Run Phillips Curve Equation. While theory posits that the Long-Run Phillips Curve is simply a perfectly vertical line located at the NAIRU, some economists believe there is a slope to the Long-Run Phillips curve.

While that topic is beyond the scope of this level of explanation, it is noteworthy to understand that there is some debate in this area.

The same holds true for the Short-Run Phillips Curve Equation. In theory, as you have read, the Short-Run Phillips Curve is, in its simplest form, a function that explains the relationship between the unemployment rate (the independent variable) and the inflation rate (the dependent variable).

We can add expected inflation to that function because of the impact that expected inflation has on the Short-Run Phillips Curve since, by definition, expected inflation shifts the Short-Run Phillips curve.

However, some economists add variables to the Short-Run Phillips Curve such as trends in wage rates, price stickiness, output gaps, and even demand elasticity.

If the Short-Run Phillips Curve Equation can be this complex, it's reasonable to infer that the Long-Run Phillips Curve Equation might also be more involved than this explanation has allowed for.

However, that is a topic you can learn more about as you advance in your economics education.

Difference Between Short-Run and Long-Run Phillips Curve

Aside from the obvious difference between the short-run and the long-run Phillips curves in the temporal sense, it's also accurate to state that, unlike the short-run Phillips curve, the Long-Run Phillips Curve takes expected inflation into account.

Expected inflation is the key difference between the short-run and the long-run Phillips curves because expected inflation can and does lead to changes in the demand for wage rates in order for households to protect their purchasing power.

If you expect all prices to be 10% higher one year from now than they are today, you would likely do whatever you could to protect your ability to purchase the same amount of goods and services in one year. This is particularly true of essential goods and services such as housing, food, clothes, and transportation.

While the efforts of households to increase their wages in accordance with expected inflation may not always be successful, it is paramount to understand that this phenomenon is precisely what distinguishes the short-run Phillips curve from the long-run Phillips curve. That is, while expected inflation shifts the short-run Phillips curve due to the shock to supply, expected inflation is inherent in the long-run Phillips curve.

Long-Run Phillips Curve - Key takeaways

• The Short-Run Phillips Curve slopes downward to illustrate the trade-off between inflation and unemployment in an economy.
• Both fiscal and monetary policy work in exactly the same manner to create the correlation between unemployment and inflation depicted in the Short-Run Phillips Curve.
• A supply shock is an event that shifts the short-run aggregate supply curve, such as a change in commodity prices, nominal wages, or productivity, and results in a shift in the Short-Run Phillips curve.
• Stagflation is an economic condition where persistently high inflation and high unemployment exist simultaneously.
• The nonaccelerating inflation rate of unemployment, or the NAIRU, is in fact where the Long-Run Phillips Curve exists, and as such is perfectly vertical.