PHILLIPS

CURVE
By – Rohan Anil & Sarfaraz
RECAP: INFLATION

Inflation is defined as the persistent increase in the price level of goods & services and decline of purchasing power in
an economy over a period of time.

There are two major types of Inflation pertaining to the Phillips curve, they are

• Hyperinflation :- represents a rapid and continuous rise in price level, period after period. A hyperinflation is generally defined
as inflation at the rate of 50 per cent or more per month. hyperinflation is generally caused when Government issues too much
currency which greatly adds to the money supply in the economy.

• Stagflation :- represents a situation where there is both a high inflation and lower output present in the economy. The rise in
price level or inflation and simultaneously fall in GDP level is called stagflation. When both inflation and recession occur
simultaneously, economists call this situation as stagflation as seen in the seventies recession or stagnation was accompanied
by not only high unemployment but also rapid inflation. Since in that period high unemployment and recession (or stagnation)
co-existed with high inflation
RECAP: UNEMPLOYMENT
Unemployment is defined as a state of affairs when in a country there are a large number of able-bodied persons of working age who
are willing to work but cannot find work at the current wage levels.

• People who are either unfit for work for physical or mental reasons, or don’t want to work, e.g., sadhus, are excluded from the
category of the unemployed.

BACKGROUND OF PHILLIPS CURVE :

• The Phillips curve is a concept in economics that explores the relationship between inflation and unemployment. The concept
is named after New Zealand economist William Phillips, who first presented it in 1958 in a paper titled "The Relationship
between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957.“

• Phillips initially observed this relationship while analysing historical data on unemployment and wage inflation in the United
Kingdom.
“William Phillips was a New Zealand-born economist who made significant contributions to the field of economics, particularly through his research on the relationship between unemployment
and inflation, which led to the development of the Phillips curve. Born in 1914 in New Zealand, Phillips gained widespread recognition for his seminal paper titled "The Relationship between
Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957," published in 1958.”
INFLATION & UNEMPLOYMENT TRADE-OFF : PHILLIPS
CURVE
• There is an inverse relationship between rate of unemployment and rate of inflation. This
inverse relation implies a trade-off, that is, for reducing unemployment, price in the form of
a higher rate of inflation has to be paid, and for reducing the rate of inflation, price in terms
of a higher rate of unemployment has to be borne.

• This trade-off between inflation and unemployment, is called the Phillips curve.

• The Phillips curve is a reflection of the short-run aggregate supply curve: as policymakers
move the economy along the short-run aggregate supply curve, unemployment and inflation
move in opposite directions. The Phillips curve is a useful way to express aggregate supply
because inflation and unemployment are such important measures of economic performance.
 GRAPHICAL REPRESENTATION OF PHILLIPS
CURVE
• Showing Negative Relationship between
Rates of Inflation and Unemployment
• The horizontal axis is the rate of
unemployment and along the vertical axis
the rate of inflation is measured.

• It is seen that when rate of inflation is

10% , the unemployment rate is 3%

• When the rate of inflation is reduced to 5 %

per annum (by pursuing contractionary
fiscal policy and thereby reducing
aggregate demand), the rate of
unemployment increases to 8% of labour
force
“What is fiscal policy?”

“Diagram is FIG-13.1 from pg 339 of Ahuja”

PHILLIPS CURVE OF THE US ECONOMY FROM THE
SIXTIES
• Drawn from the data of the United States
economy from 1961-1969

• Shows the predictable inverse relationship

between the unemployment rate and rate of
inflation

• This trade-off presents a dilemma for the policy

makers; should they choose a higher rate of
inflation with lower unemployment or a higher
rate of unemployment with a low inflation rate.

“diagram is FIG-13.2 from Ahuja; pg 339”

 KEYNESIAN EXPLANATION OF PHILLIPS CURVE
• Keynesian economists assume the upward-sloping short-run aggregate supply curve

• As the economy approaches near full-employment level the aggregate supply curve slopes upward

SAS Curve is upward sloping for two reasons :-

• As the output is increased , there will be a diminishing rate of returns to variable factors such as labour, which causes the
marginal productivity (of labour) to fall. The increase in output of these variable factors will also result in an increase in
marginal cost incurred for production.

• The second reason for the marginal cost to go up is the rise in the wage rate as employment and output are increased.
When under pressure of aggregate demand for output, demand for labour increases, its wage rate tends to rise, supply
curve of labour being upward sloping. Thus, marginal cost of firms increases as more labour is employed due to
diminishing marginal physical product of labour and also because wage rate also rises.

“SAS – Short run aggregate supply”

“Even Keynes himself believed that as the economy approached near full employment, labour shortage
might appear in some sectors of the economy causing increase in the wage rate”

“MC = - measures marginal cost”

 • The graph here illustrates that the initial aggregate demand curve AD0
and the given aggregate supply curve SAS, the price level P0 and output
level Y0 are determined. Now, suppose the aggregate demand curve
increases from AD0 to AD1 , it will be seen that price level rises to P1
and aggregate national output increases from Y0 to Y1

• Increase in aggregate national product means increase in employment of

labour and therefore reduction in unemployment rate. Thus, the rise in
the price level from P0 to P1 results in lowering of unemployment rate
showing inverse relation between the two.

• If aggregate demand increases to AD2 , the price level further rises to P2

and national output increases to Y2 which will further lower the rate of
unemployment.

• (a) Given the SAS Curve Increase in Aggregate

• A higher rate of increase in aggregate demand and consequently a higher
Demand Causes Rise in Price Level and Increase in rate of rise in price level is associated with the lower rate of
GDP. unemployment and vice versa.

“diagram is FIG-13.3 (a) from Ahuja; pg 340”

 • In this graph (b) , it is shown that the rate of unemployment equal to U3
corresponding to the price level P0 in the previous graph (a).
• When the aggregate demand shifts to AD1 , there is a certain rate of
inflation and price level rises to P1 and aggregate output increases to
Y1 . As seen above, this increase in aggregate output leads to the
increase in employment of labour bringing about decline in
unemployment rate.
• Suppose the rate of rise in the price level (i.e., the rate of inflation) when
it increases, following the increase in aggregate demand is greater than the
rate of rise in the price level of the previous period, we obtain a lower rate
of unemployment U2 than before corresponding to a higher inflation rate
P1 in the Phillips curve PC.
• With a still higher rate of inflation, say P2 , when price level rises from
P1 to P2 in the previous graph (a), following the increase in aggregate
demand to AD2 , we have a further lower rate of unemployment equal to
U1 in the current graph (b) corresponding to point c′ on the Phillips curve
PC. This gives us a downward-sloping Phillips curve PC.
(b)Inflation-Unemployment Trade-off in short-run

“diagram is FIG-13.3 (b) from Ahuja; pg 340”

 COLLAPSE OF PHILLIPS CURVE IN THE USA
• A stable Phillips curve could not hold good during the
seventies and eighties, especially in the United States.
Therefore, experience in the two decades (1971-91) has
prompted some economists to say that the stable Phillips
curve has disappeared
• The data from the above figure, shows the inflation rate and
unemployment in case of the United States in the above
illustration. From the data it appears that instead of remaining
stable, the Phillip curve shifted to the right in the seventies
and early eighties and to the left during the late eighties.

• There are periods when rates of both inflation and

unemployment increased (that is, a high rate of inflation was
associated with a high unemployment rate, which shows the
absence of trade off.

• Shift in Phillips Curve

“diagram is FIG-13.4 from Ahuja; pg 341”

 CASE STUDY OF US DATA FROM 1960-2016
• The 1960s showed how policymakers can, in the
short run, lower unemployment, leading to
demand-pull inflation.

• The tax cut of 1964, together with expansionary

monetary policy, expanded aggregate demand and
pushed the unemployment rate below 5 percent.
Unemployment fell lower and inflation rose higher
than policymakers intended.

• The 1970s were a period of economic turmoil.

President Nixon imposed temporary controls on
wages and prices, and the Fed engineered a
recession through contractionary monetary policy,
but the inflation rate fell only slightly.

• By 1972 the unemployment rate was the same as it

had been a decade earlier, while inflation was about
3 percentage points higher
“FIGURE 14-3 Inflation and Unemployment in the United States , 1960–2016”
“From Mankiw Macro Economics 10E 10th Edition”
CASE STUDY OF US DATA FROM 1960-2016
• The 1980s began with high inflation and high
expectations of inflation.

• In 1982 and 1983 the unemployment rate reached

its highest level in 40 years. High unemployment,
aided by a fall in oil prices in 1986, pulled the
inflation rate down from about 9 percent to about
2 percent.

• Unemployment continued to fall through (close to

natural rate) the 1980s, however, reaching a low
of 5.3 percent in 1989 and beginning a new round
of demand-pull inflation.

• The unemployment rate rose to 7.5 percent in

1992, and inflation fell slightly.
 CASE STUDY OF US DATA FROM 1960-2016

• Similarly, a recession in 2001 raised

unemployment, but the downturn was mild by
historical standards, and the impact on inflation
was once again slight.

• A more severe recession began in 2008.

Unemployment rose significantly in 2009, and the
inflation rate fell to low levels, much as the
conventional Phillips curve predicts.

Thus, U.S. macroeconomic history illustrates the many forces working on the inflation rate, as described in the Phillips curve equation. The 1960s and
1980s show the two sides of demand-pull inflation: in the 1960s low unemployment pulled inflation up, and in the 1980s high unemployment pulled
inflation down. The oil-price hikes of the 1970s show the effects of cost-push inflation. And the aftermath of the recession of 2008–2009 shows that
inflation sometimes surprises us, in part because changing expectations are not always easy to predict.
 CAUSES OF SHIFT IN THE PHILLIPS CURVE
• According to Keynesians, the occurrence of higher inflation rate along
with the increase in unemployment rate witnessed during the seventies
and early eighties was due to the adverse supply shocks in the form of
fourfold increase in the prices of oil and petroleum products delivered to
the American economy first in 1973-74 and then again in 1979-80.

• In the above graph, where AD0 and AS0 are in equilibrium at point E
and determine price level OP0 and aggregate national output OY0 . The
hike in price of oil by OPEC, the cartel of oil producing Middle East
countries, brought about a rise in the cost of production of several
commodities for the production of which oil was used as an energy
input.
• Further, the oil price hike also raised the transportation costs of all
commodities. The increase in cost of production and transportation of
commodities caused a shift in the aggregate supply curve upward to the
• Adverse Supply Shock Giving Rise to Stagflation and left. This is generally described as adverse supply shock which raised
Breakdown of Phillips Curve the unit cost at each level of output.

“diagram is FIG-13.5 from Ahuja; pg 341”

 • It will be seen from the above figure that due to this adverse supply
shock; aggregate supply curve has shifted to the left to the new position
AS1 which intersects the given aggregate demand curve AD0 at point H.

• At the new equilibrium point H, price level has risen to P1 and output
has fallen to OY1 which will cause unemployment rate to rise.

• we have a higher price level with a higher unemployment rate. This

explains the rise in the price level with the rise in the unemployment
rate, the phenomenon which was witnessed during the seventies and
early eighties in developed countries such as the U.S.A.

• this has been interpreted by some economists as a shift in the

Phillips curve and some as demise or collapse of the Phillips
• Adverse Supply Shock Giving Rise to Stagflation and curve.
Breakdown of Phillips Curve

“diagram is FIG-13.5 from Ahuja; pg 341”

 FRIEDMAN’S VIEW
• According to Friedman there is a trade-off between rate of inflation and unemployment in the short run, that
is, there exists a short-run downward sloping Phillips curve, but it is not stable and it often shifts both
leftward and rightward. He argued that there is no long run stable trade-off between rates of inflation and
unemployment.

• Friedman’s natural rate hypothesis states that though there is trade-off between inflation and
unemployment in the short run, in the long run economy comes back to be in stable equilibrium at the
natural rate of unemployment. Therefore, according to him, the long-run Phillips curve is a vertical
straight line.

NATURAL RATE OF UNEMPLOYMENT

The natural rate of unemployment is the rate at which, in the labour market the current number of
unemployed is equal to the number of jobs available. These unemployed workers are not employed for the
frictional and structural reasons, though the equivalent number of jobs are available for them.

“Natural Rate Hypothesis - fluctuations in aggregate demand affect output and employment in the short run, in the long run, the economy returns to the level of natural unemployment.”

“Milton Friedman was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and
theory and the complexity of stabilization policy. With George Stigler, Friedman was among the intellectual leaders of the Chicago school of economics, a neoclassical school of economic thought
associated with the work of the faculty at the University of Chicago that rejected Keynesianism in favour of monetarism until the mid-1970s, when it turned to new classical macroeconomics
heavily based on the concept of rational expectations”
• For instance, due to lack of information or lack of mobility the fresh entrants to the labour force may spend a good deal of time
in searching for the jobs before they are able to find work. This is called frictional unemployment.

• Besides, some industries may be registering a decline in their production rendering some workers unemployed, while others may
be growing and therefore creating new jobs for workers. But the unemployed workers may have to be provided new training and
skills before they are employed in the newly created jobs in the growing industries. This is structural unemployment.

• These frictional and structural unemployment's constitute the natural rate of unemployment.

• Since the equivalent number of jobs are available for them, full employment is said to prevail even in the presence of this natural
rate of unemployment. It is presently believed that 4 to 5 per cent rate of unemployment represents a natural rate of
unemployment in the developed countries.

• However, this natural rate of unemployment is not constant but varies over time due to changes in mobility and availability of
information. If mobility of workers increases and quick information about new jobs are available frictional unemployment falls.
Similarly, if facilities for training unemployed workers and equipping them with new skills required for available jobs increase
structural unemployment will decline.
LONG-RUN PHILLIPS CURVE : RATIONAL
EXPECTATIONS
• Friedman’s adaptive expectations theory assumes that nominal wages lag behind changes in the price level. This lag in the
adjustment of nominal wages to the price level brings about rise in business profits which induces the firms to expand output
and employment in the short run and leads to the reduction in unemployment rate below the natural rate.

• According to the rational expectations theory, which is another version of natural unemployment rate theory, there is no
lag in the adjustment of nominal wages consequent to the rise in price level.

• This theory further argue that nominal wages are quickly adjusted to any expected changes in the price level so that there does
not exist the type of Phillips curve that shows trade-off between rates of inflation and unemployment. As a result of increase in
aggregate demand, there is no reduction in unemployment rate.

• The rate of inflation resulting from increase in aggregate demand is fully and correctly anticipated by workers and business
firms and get completely and quickly incorporated into the wage agreements resulting in higher prices of products.
RATIONAL EXPECTATIONS
• As shown in the figure (a), it is the price level
that rises, the level of real output and
employment remaining unchanged at the natural
level. Hence, aggregate supply curve according
to the rational expectations theory is a vertical
straight line at the potential GNP level, that is, at
the natural rate of unemployment, given the
resources and technology.

• Long-run Phillips curve, according to rational

expectations theory, corresponds to this long-run
aggregate supply curve and is a vertical straight
line at the natural unemployment rate as shown
in figure (b).

a)Inflation and National Output : b)According to Rational Expectations Theory, Long

Rational Expectations Theory run Phillips Curve is a Vertical Straight Line.
“diagrams are FIG-13.7 & FIG-13.8 from Ahuja; pg 345”
RATIONAL EXPECTATIONS
Rational expectations theory rests on two basic
elements.

• First, according to it, workers and producers being

quite rational have a correct understanding of the
economy and therefore correctly anticipate the
effects of the Government’s economic policies
using all the available relevant information.

• On the basis of these anticipations of the effects of

economic events and Government’s policies they
take correct decisions to promote their own
interests

a)Inflation and National Output : b)According to Rational Expectations Theory, Long

Rational Expectations Theory run Phillips Curve is a Vertical Straight Line.
“diagrams are FIG-13.7 & FIG-13.8 from Ahuja; pg 345”
RATIONAL EXPECTATIONS
• The second premise of rational expectations theory
is that, like the classical economists, it assumes that
all product and factor markets are highly
competitive. As a result, wages and product prices
are highly flexible and therefore can quickly change
upward and downward

• the rational expectations theory considers that new

information is quickly assimilated in the demand
and supply curves of markets so that new
equilibrium prices immediately adjust to the new
economic events and policies, be it a new
technological change or a supply shock such as a
drought or act of OPEC oil cartel or change in
Government’s monetary and fiscal policies.

a)Inflation and National Output : b)According to Rational Expectations Theory, Long

Rational Expectations Theory run Phillips Curve is a Vertical Straight Line.

“diagrams are FIG-13.7 & FIG-13.8 from Ahuja; pg 345”

RATIONAL EXPECTATIONS

• Figure (a) illustrates the standpoint of rational expectations theory about

the relation between inflation and unemployment. In this OȲ is the level
of real potential output corresponding to the full employment of labour
(with a given natural rate of unemployment). LAS is aggregate supply
curve at OȲ level of real potential long-run output.

• To begin, AD0 is the aggregate demand curve which intersects the

aggregate supply curve LAS at point A and determines price level equal to
P0 and SAS0 is the short-run aggregate supply curve.

• Suppose Government adopts an expansionary monetary policy to

increase output and employment. As a consequence, aggregate demand
curve shifts upward to the new position AD1.

a)Inflation and National Output :

Rational Expectations Theory

“diagram is FIG-13.7 from Ahuja; pg 345”

RATIONAL EXPECTATIONS

• According to rational expectations theory, people (workers, businessmen,

consumers, lenders) will correctly anticipate that this expansionary policy
will cause inflation in the economy, and they would take prompt measures
to protect themselves against this inflation.

• Accordingly, workers would press for higher wages and get it granted,
businessmen would raise the prices of their products, lenders would hike
their rates of interest. All these increases would take place immediately.

• It is thus clear that the increase in aggregate demand (i.e., aggregate

expenditure) brought about by expansionary monetary policy will cause
the equilibrium to shift to point B and price level will rise to P1.

a)Inflation and National Output :

Rational Expectations Theory

“diagram is FIG-13.7 from Ahuja; pg 345”

RATIONAL EXPECTATIONS
• Thus, the increase in aggregate demand or expenditure will be fully
reflected in higher wages, higher interest rates and higher product
prices, all of which will rise in proportion to the anticipated rate of
inflation.

• Consequently, the levels of real national product (which is equal to

potential GNP), real wage rate, real interest rate, would remain
unchanged.
In rational expectations theory, the economy does not move
temporarily from macro equilibrium at A to E in the short run along
the short-run aggregate supply curve SAS0.

• When aggregate demand shifts from AD0 to AD1 , short-run

supply curve shifts immediately from SAS0 to SAS1 as a result of
immediate and quick adjustment in wages and other input prices
a)Inflation and National Output : due to correct anticipation of rate of inflation
Rational Expectations Theory

“diagram is FIG-13.7 from Ahuja; pg 345”

RATIONAL EXPECTATIONS
• Similarly, when aggregate demand curve shifts rightward from AD1 to AD2 as
a consequence of expansionary monetary or fiscal policy of government, the
workers and other input suppliers will correctly anticipate the further rise in
price level and will make quickly further upward adjustment in prices.

• And again, due to the correct anticipation of the rate of inflation, the rise in
wages and other input prices will be in proportion to the rate of inflation. As a
result, short-run aggregate supply curve immediately shifts from SAS1 to SAS2
and price level rises to P2 corresponding to the new equilibrium point C.

According to the rational expectations theory, the intended effect of

a)Inflation and National Output :
Rational Expectations Theory
expansionary monetary policy on investment, real output and employment does
not materialise. As seen in the figure, it is due to the anticipation of inflation by
the people and quick upward adjustments made in wages, interest etc., by them
that the price level instantly rises from P0 to P1 and from P1 to P2 , the level of
output OY remaining constant.

“diagram is FIG-13.7 from Ahuja; pg 345”

RATIONAL EXPECTATIONS
a)Inflation and National Output :
Rational Expectations Theory
“diagram is FIG-13.7 from Ahuja; pg 345”
• That is why, according to the rational expectations theory, aggregate
supply curve is a vertical straight line. The vertical aggregate supply
curve means that there is no trade-off between inflation and
unemployment, that is, downward-sloping Phillips curve does not exist.
Thus, according to rational expectations theory, the increase in
aggregate demand or expenditure as a consequence of easy
monetary policy of the Government will fail to reduce
unemployment and instead will only cause inflation in the
economy.
It is important to note that according to rational expectations theory long-run
aggregate supply curve is a vertical straight line at potential GNP level such as LAS
in the figure. This is due to the correct anticipation of rate of inflation by the workers
and other suppliers of inputs. If inflation rate was more than the expected or
anticipated rate, the unemployment rate would have fallen below the natural level
and GNP would have been greater than the potential level.
RATIONAL EXPECTATIONS
a)Inflation and National Output :
Rational Expectations Theory
“diagrams are FIG-13.7 & FIG-13.8 from Ahuja; pg 345”
• In Rational expectations theory; aggregate supply
curve LAS is vertical in the long run, the long-run
Phillips curve is also vertical at the natural
unemployment rate.
• The long-run Phillips curve shows relationship
between inflation and unemployment when the
actual inflation rate equals the anticipated inflation
rate.
• The vertical long-run Phillips curve shows that
whatever the anticipated inflation rate, the long-run
equilibrium is at the natural unemployment rate. As
depicted by AS-AD model in figure (b), the long-
run Phillips curve corresponds to the vertical long-
run aggregate supply curve at the potential GNP
level.
b)According to Rational Expectations Theory, Long
run Phillips Curve is a Vertical Straight Line.
ADAPTIVE EXPECTATION
• Friedman put forward a theory of adaptive expectations according to
which people form their expectations on the basis of previous period rate of
inflation, and change or adapt their expectations only when the actual
inflation turns out to be different from their expected rate.
• there may be a trade-off between rates of inflation and unemployment in
the short run, but there is no such trade-off in the long run.
The view of Friedman and his follower monetarists is illustrated in the abov
figure
• SPC1 is the short-run Phillips Curve, and the economy is at point A0 , on it
corresponding to the natural rate of unemployment equal to 5% of labour
force. The location of this point A0 on the short-run Phillips curve depends
on the level of aggregate demand.

• Further, we assume that the economy has been experiencing a rate of

inflation equal to 5%. The other assumption we make is that nominal
• Shift in Short-run Phillips Curve and Long-run
wages have been set on the expectations that 5% rate of inflation will
Phillips Curve. continue in the future.

“diagram is FIG-13.6 from Ahuja; pg 343”

 • suppose for some reasons the government adopts expansionary fiscal and
monetary policies to raise aggregate demand

• The consequent increase in aggregate demand will cause the rate of inflation to
rise, say, to 7%. Given the level of money wage rate which was fixed on the
basis that the 5% rate of inflation would continue to occur, the higher price
level than expected would raise the profits of the firms which will induce the
firms to increase their output and employ more labour.
• As a result of the increase in aggregate demand resulting in a higher rate of
inflation and more output and employment, the economy will move to point A1
on the short-run Phillips curve SPC1 in the above figure, where unemployment
has decreased to 3.5% while inflation rate has risen to 7%.

• It may be noted that in moving from point A0 to A1 , on SPC1 the economy

accepts a higher rate of inflation as the cost of achieving a lower rate of
unemployment.

• Shift in Short-run Phillips Curve and Long-run

Phillips Curve.

“diagram is FIG-13.6 from Ahuja; pg 343”

 • Thus, this is in conformity with the concept of Phillips curve explained
earlier though the advocates of natural unemployment rate hypothesis
interpret it in a slightly different way. They think that lower rate of
unemployment achieved is only a temporary phenomenon

• They think when the actual rate of inflation exceeds the one that is
expected, unemployment rate will fall below the natural rate only in the
short run. In the long run, the natural rate of unemployment will be
restored

LONG RUN PHILLIPS CURVE :

• According to them, the economy will not remain in a stable equilibrium
position at A1 . This is because the workers will realise that due to the highe
rate of inflation than the expected one, their real wages and incomes have
fallen.
• Shift in Short-run Phillips Curve and Long-run
Phillips Curve.

“diagram is FIG-13.6 from Ahuja; pg 343”

 • The workers will therefore demand higher nominal wages to restore
their real income. But as nominal wages rise to compensate for the
higher rate of inflation than expected, profits of business firms will fall
to their earlier levels.

• This reduction in their profit implies that the original motivation that
prompted them to expand output and increase employment resulting in
lower unemployment rate will no longer be there.

• Consequently, they will reduce employment till the unemployment rate

rises to the natural level of 5%. That is, with the increase in nominal
wages in the above figure, the economy will move from A1 to B0 , at a
higher inflation rate of 7%.

• It may be noted that the higher level of aggregate demand which

generated inflation rate of 7% and caused the economy to shift from A0
to A1 still persists.
• Shift in Short-run Phillips Curve and Long-run
Phillips Curve.

“diagram is FIG-13.6 from Ahuja; pg 343”

 • At point B0 , and with the actual rate of inflation equal to 7% , the
workers will now expect this 7% inflation rate to continue in future. As a
result, the short-run Phillips curve SPC shifts upward from SPC1 to SPC2
.
The movement along a short-run Phillips curve SPC is only a temporary or
short-run phenomenon. In the long run when nominal wages are fully
adjusted to the changes in the inflation rate and consequently
unemployment rate comes back to its natural level, a new short-run Phillips
curve is formed at the higher expected rate of inflation.
The above process of reduction in unemployment rate and then its returning
to the natural level may continue further.

• The Government may misjudge the situation and think that 7% rate of
inflation is not too high and adopt expansionary fiscal and monetary
policies to increase aggregate demand and thereby to expand the level of
employment. With the new increase in aggregate demand, the price level
• Shift in Short-run Phillips Curve and Long-run will rise further with nominal wages lagging behind in the short run.
Phillips Curve.

“diagram is FIG-13.6 from Ahuja; pg 343”

 • As a result, profits of business firms will increase, and they will expand
output and employment causing the reduction in rate of unemployment
and rise in the inflation rate.

• With this, the economy will move from B0 to B1 along their short-run
Phillips curve SPC2 . After some time, the workers will recognise the
fall in their real wages and press for higher normal wages to
compensate for the higher rate of inflation than expected.

• When this higher nominal wages are granted, the business profits
decline which will cause the level of employment to fall and
unemployment rate to return to the natural rate of 5%.
• The economy moves from point B1 to C0 . The new short-run
Phillips curve will now shift to SPC3 passing through point C0 .

• The process may be repeated again with the result that while in the
short run, the unemployment rate falls below the natural rate and in
• Shift in Short-run Phillips Curve and Long-run the long run it returns to its natural rate. But throughout this process
Phillips Curve. the inflation rate continuously goes on rising.
“diagram is FIG-13.6 from Ahuja; pg 343”
 • On joining points such as A0 , B0 , C0 corresponding to the given natural
rate of unemployment we get a vertical long-run Phillips curve LPC.

• The adaptive expectations theory of the natural rate hypothesis while the
short run Phillips curve is downward sloping indicating that trade off
between inflation and unemployment rate in the short run, the long-run
Phillips curve is a vertical straight line showing that no trade-off exists
between inflation and unemployment in the long run.

Adaptive expectations theory has also been applied to explain the reverse
process of disinflation, that is, fall in the rate of inflation as well as inflation
itself.
• Suppose the economy is originally at point C0 with 9% rate of inflation.
Now, if a decline in aggregate demand occurs, say as a result of contraction
of money supply by the Central Bank of a country, this will reduce inflation
• Shift in Short-run Phillips Curve and Long-run rate below the 9% expected rate.
Phillips Curve.

“diagram is FIG-13.6 from Ahuja; pg 343”

 • As a result, profits of business firms will decline because the prices will
be falling more rapidly than wages. The decline in profits will cause the
firms to reduce employment and consequently unemployment rate will
rise.

• Eventually, firms and workers will adjust their expectations and the
unemployment rate will return to the natural rate. The process will be
repeated and the economy in the long run will slide down along the
vertical long-run Phillips curve showing falling rate of inflation at the
given natural rate of unemployment.

According to Adaptive Expectations Theory ; any rate of inflation can

occur in the long run with the natural rate of unemployment.

• Shift in Short-run Phillips Curve and Long-run

Phillips Curve.

“diagram is FIG-13.6 from Ahuja; pg 343”

 RELATIONSHIP BETWEEN SHORT-RUN PHILLIPS
CURVE AND LONG-RUN PHILLIPS CURVE
The position of a short-run Phillips curve (SPC) which passes through a
point on the long-run Phillips curve (LPC) depends on the anticipated
inflation rate
• Short-run Phillips curve is like the short-run aggregate supply curve which is
drawn with a given expected price level.

• Short-run Phillips curve is also drawn with an anticipated inflation rate, and
it will shift as the expected inflation rate changes. This is depicted in the
illustrated figure, If the expected inflation rate is 9% a year, then, as will be
seen from the figure, the short-run Phillips curve SPC0 passes through the
corresponding point A on the long-run Phillips curve LPC with natural
unemployment rate of 5%.
• The movement along a short-run Phillips curve occurs as a result of changes
in aggregate demand.
• Long-run Phillips Curve and Shift in
Short-run Phillips Curve

“diagrams is FIG-13.9 from Ahuja; pg 347”

 RELATIONSHIP BETWEEN SHORT-RUN PHILLIPS
CURVE AND LONG-RUN PHILLIPS CURVE
• When there is unanticipated Y increase in aggregate demand, inflation rate
rises more than the expected rate and GNP increases causing a fall in
unemployment rate, we move upward to the left from point A on the short-
run Phillips curve SPC0 .

• On the other hand, when there is unanticipated decrease in aggregate

demand, inflation rate falls, and unemployment rate increases above the
natural rate and as a result we move downward to the right from point A
along the short-run Phillips curve SPC0.

• Although, when the expected inflation rate changes, the short-run Phillips
curve shifts.

• Long-run Phillips Curve and Shift in Short-

run Phillips Curve

“diagrams is FIG-13.9 from Ahuja; pg 347”

 RELATIONSHIP BETWEEN SHORT-RUN PHILLIPS
CURVE AND LONG-RUN PHILLIPS CURVE
• For example, when the expected inflation rate is 9% a year, the short-run
Phillips curve is SPC0 in the figure. If the expected inflation rate falls to
6% a year, the short-run Phillips curve shifts below to SPC1 .

• The new short-run Phillips curve passes through long-run Phillips curve
at the new expected inflation rate of 6%. The distance by which the short-
run Phillips curve shifts to a lower position is equal to the change in the
expected rate of inflation.

THE SHORT-RUN PHILLIPS CURVE SHIFTS DOWNWARD

WHEN THE EXPECTED INFLATION RATE FALLS
• To begin with, the expected inflation rate of 9% a year prevails. To check
this inflation rate the Central Bank of a country will take steps to lower
the growth in money supply. As a result, actual inflation rate falls to 6%
• Long-run Phillips Curve and Shift in
a year.
Short-run Phillips Curve

“diagrams is FIG-13.9 from Ahuja; pg 347”

 THE SHORT-RUN PHILLIPS CURVE SHIFTS DOWNWARD WHEN THE
EXPECTED INFLATION RATE FALLS

• At first the fall in actual inflation rate is unanticipated and therefore the wages
and other input prices continue to rise at their original rate consistent with 9%
expected inflation rate and there is rightward movement along the short-run
Phillips curve SPC0 resulting in fall in GNP and increase in unemployment
rate.
• However, when the inflation rate remains steady at 6% a year, this rate
eventually comes to be anticipated. As this happens, increase in wage rate and
other input prices slows down and with the expected increase in aggregate
demand; GNP increases and unemployment rate falls to the natural level.

As a result, the short-run Phillips curve shifts downward to the new position
SPC1 that corresponds to the new lower expected inflation rate of 6% a year.
• Long-run Phillips Curve and Shift in
Short-run Phillips Curve

“diagrams is FIG-13.9 from Ahuja; pg 347”

Thank You