Lecture 15 - The Phillips Curve and the Short-Run Trade-Off

Overview

This lecture introduces the Phillips Curve, which captures the short-run relationship between inflation and unemployment. It builds directly on the AD–AS framework and shows how macroeconomic policy can influence real variables in the short run, but not in the long run.

The Phillips Curve: Core Idea

Definition

The Phillips Curve describes a negative relationship between inflation and unemployment in the short run.

  • First identified by A.W. Phillips (1958) using UK data (1861–1957)
  • Suggests a trade-off:
    • Low unemployment → high inflation
    • High unemployment → low inflation
Economic Intuition

When demand in the economy is strong, firms increase output and hire more workers, reducing unemployment. However, this also increases wage pressures and production costs, leading to higher inflation.

The Phillips Curve and AD–AS

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_8_set1/Slide5.png

This diagram links the AD–AS model to the Phillips Curve. A shift in aggregate demand moves the economy along the short-run aggregate supply curve, changing both output and the price level. These changes translate into movements along the Phillips Curve.

  • Low AD → low output, high unemployment, low inflation (Point A)
  • High AD → high output, low unemployment, high inflation (Point B)
Theoretical Interpretation

The Phillips Curve is not an independent relationship. It is derived from the AD–AS model via the output–price adjustment process. Higher demand increases output temporarily because wages and expectations adjust slowly.

Summary
  • AD shifts drive movements along the Phillips Curve
  • Inflation and unemployment are jointly determined in the short run
  • The trade-off reflects temporary deviations from equilibrium

The Long-Run Phillips Curve (LRPC)

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_8_set1/Slide7.png

In the long run, the Phillips Curve becomes vertical at the natural rate of unemployment.

  • Expansionary policy increases inflation only
  • No permanent effect on unemployment
Definition

The natural rate of unemployment is the level determined by structural factors such as labour market institutions, search frictions, and wage-setting mechanisms.

Theoretical Interpretation

This reflects the classical dichotomy: nominal variables (like inflation) do not affect real variables (like unemployment) in the long run.

Summary
  • Long-run Phillips Curve is vertical
  • No long-run trade-off
  • Monetary policy is neutral in the long run

Expectations and the Phillips Curve

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_8_set1/Slide10.png

The short-run Phillips Curve depends on the difference between actual and expected inflation.

Definition

The expectations-augmented Phillips Curve:

where:

  • = unemployment
  • = natural rate
  • = actual inflation
  • = expected inflation
Economic Intuition

Only unexpected inflation affects unemployment. If inflation is higher than expected, real wages fall, firms hire more workers, and unemployment decreases.

Common Mistake

Thinking policymakers can permanently choose a point on the Phillips Curve. This is incorrect because expectations adjust over time.

Breakdown of the Phillips Curve (1970s)

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_8_set1/Slide14.png

Empirical evidence from the 1970s showed that both inflation and unemployment were high simultaneously.

  • Known as stagflation
  • Caused by:
    • Rising inflation expectations
    • Supply shocks (e.g. oil crises)
Theoretical Interpretation

This breakdown supports the Friedman–Phelps view that the Phillips Curve shifts with expectations. There is no stable trade-off.

Summary
  • Phillips Curve is not stable
  • Expectations shift the curve