2.6.4. Short-Run Phillips Curve

This study note for Edexcel economics looks at the short run Phillips curve

Key Concepts

• Short-Run Phillips Curve (SRPC): Depicts a negative relationship between inflation and unemployment. As unemployment decreases, inflation tends to increase, and vice versa.
• Inflation: The rate at which the general level of prices for goods and services is rising.
• Unemployment: The condition where individuals who are capable of working and are actively seeking work are unable to find employment.
• Natural Rate of Unemployment (NAIRU): The level of unemployment at which inflation does not accelerate; also known as the Non-Accelerating Inflation Rate of Unemployment.

Short-Run Phillips Curve Diagram

See the accompanying video

In this diagram:

• The vertical axis represents the inflation rate.
• The horizontal axis represents the unemployment rate.
• The downward sloping curve shows the inverse relationship between inflation and unemployment in the short run.

Theoretical Background

1. A.W. Phillips (1958): Analyzed wage inflation and unemployment data in the UK and found an inverse relationship.
2. Milton Friedman and Edmund Phelps (1968): Challenged the Phillips curve by introducing expectations. They argued that the relationship is only temporary and in the long run, the economy adjusts, rendering the curve vertical at the natural rate of unemployment.

Real-World Applications

• 1970s Stagflation: The 1970s experienced high inflation and high unemployment simultaneously, contradicting the traditional Phillips curve. This led to the development of the expectations-augmented Phillips curve, where inflation expectations play a crucial role.
• Monetary Policy: Central banks use the Phillips curve framework to make decisions about interest rates. For instance, during periods of high unemployment, they might lower interest rates to stimulate spending and reduce unemployment, accepting higher inflation as a consequence.

Key Economists and Their Contributions

• A.W. Phillips: Introduced the concept of the Phillips curve in 1958.
• Milton Friedman: Developed the expectations-augmented Phillips curve, arguing that inflation expectations adjust over time, making the Phillips curve vertical in the long run.
• Edmund Phelps: Independently developed similar ideas to Friedman about the natural rate of unemployment.
• Janet Yellen: As a key figure in modern macroeconomics and a former chair of the Federal Reserve, Yellen's work has often focused on the trade-offs central banks face between inflation and unemployment.
• Claudia Goldin: Though her primary focus is labor economics, Goldin's research on the historical evolution of labor markets contributes to understanding unemployment trends, which are crucial for analyzing the Phillips curve.

Different Economic Perspectives

• Keynesian Perspective: Supports the view of a stable short-run trade-off between inflation and unemployment, advocating for active fiscal and monetary policies to manage economic cycles.
• Monetarist Perspective: Emphasizes the role of inflation expectations and argues that the trade-off is only short-term. Long-term policies should focus on controlling inflation through monetary policy.
• New Classical Perspective: Believes that any short-run trade-off is due to misperceptions about prices and wages. In the long run, the economy is always at the natural rate of unemployment due to rational expectations.

Timeline of Key Events

• 1958: A.W. Phillips publishes his findings on the inverse relationship between wage inflation and unemployment.
• 1960s: The Phillips curve becomes a popular tool for policymakers.
• 1970s: Stagflation challenges the Phillips curve, leading to the development of the expectations-augmented model.
• 1980s: Central banks start focusing on controlling inflation expectations.
• 2008: Global financial crisis revives interest in the Phillips curve as central banks grapple with high unemployment and low inflation.

Glossary

• Expectations-Augmented Phillips Curve: A modification of the original Phillips curve that incorporates expectations of future inflation.
• Inflation: The rate at which the general level of prices for goods and services is rising.
• Natural Rate of Unemployment (NAIRU): The level of unemployment at which inflation does not accelerate.
• Stagflation: A situation in which inflation and unemployment are both high simultaneously.

Essay Questions

1. Discuss the implications of the expectations-augmented Phillips curve for monetary policy.
2. Evaluate the relevance of the short-run Phillips curve in today's economic environment.
3. How did the experience of stagflation in the 1970s change economists' understanding of the Phillips curve?
4. Compare and contrast the Keynesian and Monetarist perspectives on the Phillips curve.
5. Analyze the role of inflation expectations in shaping the relationship between inflation and unemployment.

These study notes provide a comprehensive overview of the short-run Phillips curve, touching on theoretical foundations, real-world applications, and various economic perspectives, aiding students in understanding this crucial concept in macroeconomics.