The Long-Run Phillips Curve
The Phillips Curve is a trade-off between inflation and unemployment that holds in the short run.
In the short run you can accept unemployment level and inflation level at point A or you can move to point B where you lower unemployment to at the cost of higher inflation level .
However, remember the properties of the Phillips Curve:
– It is downward sloping.
– The whole curve shifts up if price expectations rise.
– The curve shifts down if price expectations fall.
If you try to lower unemployment with an expansionary policy, then you move up the Phillips Curve, and have higher inflation. But once workers adjust their expectations of prices upwards, the whole curve will start to shift upwards as well.
So you will get a situation like this:
There are a few things going on here:
1. The government has decided that it wants to lower the rate of unemployment below , which we will treat here as being the natural rate of unemployment or the NAIRU. So it has used an expansionary policy to move from A to B which meant in the short run, inflation rose from to as unemployment fell from to .
2. Once workers and firms realised that inflation had risen, this changed price expectations, which meant that the whole Phillips Curve shifted upwards so we went from SRPC1 (Short Run Phillips Curve 1) to SRPC2.
3. Now if the government had abandoned its expansionary policy, then in the medium run output would return to the natural level of output which would mean employment would return to the natural rate of employment hence unemployment would return to the natural rate of unemployment. So we would be at position C. Inflation would now be constant again as we were at which here we defined as the NAIRU, but it would be higher than it was at the beginning when we were at point A. Inflation has risen from to .
4. If the government wanted to continue with its expansionary policy to keep unemployment down at then it would have to move up the new Phillips Curve SRPC2, to get to point D, where inflation was higher still at .
Notice how we have a short-run movement up the black curve from A to B, but then if the government wants to maintain the policy for longer, we have a steeper blue curve from A to D. If they wanted to carry on this expansionary policy even longer, then we would have a steeper curve still – the government would have to accept an even higher rate of inflation in order to keep unemployment below the natural rate.
And even if they did, they would be fighting a losing battle, as eventually unemployment would return to the natural rate anyway. The economic intitution here is that basically you are trying to ‘cheat’ the supply conditions of the economy. To lower unemployment below the natural rate of unemployment, you have to increase output above the natural level of output. Now as the economy can’t really sustain this level of output, you will get inflation, this always happens when there is an excess of demand over supply, demand for production is outstripping the capacity of the economy to produce it and so this will drive up prices and drive up wages for a time, but in the end workers cannot produce the impossible, and output will slip back to the natural level eventually, just with a lot of price rises until then.
This is why in the long run, the Long Run Phillips Curve is a vertical line at the NAIRU.
The moral of the story is, you can’t cheat the supply conditions of the economy forever. You can only use the ‘trade-off’ relationship between inflation and unemployment which is held in the Phillips Curve, in the short run, if you try to sustain it for too long unemployment will go back to the natural rate anyway, but you will get a lot of inflation along the way. If you want a permanent reduction in unemployment, you have to change the supply conditions.