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The Short-Run and Long-Run Phillips Curve
IB DP Economics — Unit 3: Macroeconomics | HL | 3.3 Macroeconomic Objectives [HL Extension]
📋 What You Will Learn
- Identify the original Phillips curve relationship and explain the trade-off between inflation and unemployment
- Explain the distinction between the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC)
- Analyse how shifts in the SRPC occur due to supply shocks and changes in inflationary expectations
- Explain the concept of the non-accelerating inflation rate of unemployment (NAIRU) and its relationship to the LRPC
- Apply the expectations-augmented Phillips curve to evaluate the effectiveness of demand-management policies
- Evaluate the limitations of the Phillips curve as a policy tool, including the stagflation critique
🔍 Guiding Question Can governments permanently reduce unemployment by accepting higher inflation, or does the economy always return to a natural rate of unemployment regardless of policy?
🌍 Why This Matters Between 2021 and 2023, the United States experienced its most dramatic test of Phillips curve theory in decades: unemployment fell to 3.4% — a 54-year low — while inflation surged to 9.1% in June 2022. The Federal Reserve then raised interest rates aggressively, cooling inflation to around 3% by late 2023 while unemployment barely rose above 4%. Whether this "soft landing" vindicates or challenges the Phillips curve framework is one of the most debated questions in contemporary macroeconomics.
The Original Phillips Curve: An Empirical Discovery
In 1958, New Zealand economist A.W. Phillips published a study of UK data from 1861 to 1957, finding a stable inverse relationship between the rate of wage inflation and the unemployment rate. This was quickly reinterpreted as a trade-off between price inflation and unemployment — and became one of the most influential ideas in post-war economic policy.
📖 Definition — The Phillips Curve (Original) The Phillips curve is a graphical representation of the empirically observed inverse relationship between the rate of inflation and the rate of unemployment in an economy. It suggests that lower unemployment is associated with higher inflation, and vice versa.
The intuition behind the original curve is straightforward: when unemployment is low, workers have bargaining power and can demand higher wages. Firms pass these higher labour costs on as higher prices, generating inflation. When unemployment is high, workers accept lower wages, reducing cost-push pressure and keeping inflation low.
- Policy implication (1960s): governments believed they could "choose" a point on the curve — accepting more inflation in exchange for less unemployment, or vice versa
- Demand management: expansionary fiscal or monetary policy would move the economy up and left along the curve (lower unemployment, higher inflation); contractionary policy would move it down and right
- The curve appeared stable: policymakers treated it as a reliable menu of policy options throughout the 1960s
The Short-Run Phillips Curve (SRPC)
In modern macroeconomics, the original Phillips curve is understood as a short-run relationship — valid only when inflationary expectations are fixed. The SRPC shows the trade-off between inflation and unemployment that exists at a given level of expected inflation.
📖 Definition — Short-Run Phillips Curve (SRPC) The short-run Phillips curve (SRPC) shows the inverse relationship between the inflation rate and the unemployment rate, holding inflationary expectations constant. Each SRPC is drawn for a specific level of expected inflation.
- Movement along the SRPC: caused by changes in aggregate demand — expansionary policy moves the economy up-left (lower unemployment, higher inflation); contractionary policy moves it down-right
- Shift of the SRPC: caused by a change in inflationary expectations or a supply shock — the entire curve shifts upward (worse trade-off) or downward (better trade-off)
- Each SRPC corresponds to a specific expected inflation rate: SRPC₁ might be drawn for expected inflation of 2%; SRPC₂ for expected inflation of 5%
- Higher expected inflation shifts the SRPC upward: at any given unemployment rate, actual inflation is higher because workers and firms build higher expectations into wage and price