The Phillips Curve

The Phillips CurveThe relationship between inflation and unemployment

The Phillips Curve Based on the work of a New Zealand

economist, the Phillips curve presents a relationship between the

rate of inflation and the unemployment rate.

The Phillips curve argues that there is an inverse relationship between

the two economic statistics.

The Phillips Curve

The Phillips CurveAccording to the theory, economic policymakers would have to

choose between either high unemployment or high rates of inflation

AD and the Phillips curveIt was argued that changes in AD would lead to either an increasing price level and lower unemployment rates, or a decreasing price

level and higher unemployment rates

The Phillips Curve in the 1960s

The Phillips Curve in the 1960s

Economic policy makers seemed to accept the validity of the Phillips curve through the 1960s, as aggregate supply was relatively

stable.

As Keynesian thinking was widely accepted, economists reasoned that by influencing the level of aggregate demand in the economy,

they could simply choose either high inflation with low unemployment or low

inflation with high unemployment.

Welcome to the 1970s

The Phillips Curve in the 1970s

Negative supply-shocks of the 1970s, especially those caused by OPEC’s

reduction of oil output and world crop failures led to large increases in the

price of oil and food.

All of a sudden, aggregate supply didn’t seem so stable anymore

Negative Supply Shocks and Stagflation

Stagflation The negative supply shocks led to both

an increasing price level and less output (more unemployment). This

contradicted the idea behind the Phillips curve, which said you would only have

one negative situation.

These events led to the idea of the Phillips curve shifting upwards….

The unhappy 1970s

Friedman’s take on the Phillips Curve

Short-run vs. Long-run

Friedman argued that the trade-off between the rate of inflation and the unemployment rate was only a temporary situation. He made a distinction between a short-run Phillips curve and a

long-run Phillips curve.

Short-run Phillips curve

Friedman accepted the idea of an inverse relationship between the rate of inflation and the unemployment rate in

the short-run, as Phillips originally argued.

Long-run Phillips curve

Friedman dismissed the trade-off between the inflation rate and the unemployment rate in the long-run. He argued that the long-run Phillips curve is a vertical line at the “natural rate of

unemployment”.

As a neo-classicist, Friedman argued that increases in AD would lead to an increase in output (less

unemployment) and higher average prices, but in the long-run, the gains in output would be offset by

a leftward shift of the SRAS curve

Remember?

So according to Friedman..

The government can only lower unemployment rates in the short run using aggregate demand policies, and this will come with an increasing price

level.

In the long-run, the unemployment rate will return to the natural rate, and this can only be lowered using the supply-

side policies you know so well….