Philips Curve

The Philips curve shows the relationship between unemployment and inflation.

SR Philips Curve

In the short run, the Philips curve shows that inflation is inversely proportional to unemployment. This means that if you try to reduce unemployment, inflation will increase.

As unemployment reduces from 6% -> 2%, inflation rises from 1% -> 6%
This is due to demand pull inflation / tightening of the labour (rising wages).

Stagflation

Stagflation is where unemployment and inflation is high at the same time. It can occur when there are supply side shocks. These cause cost push inflation, regardless of unemployment levels. One example of stagflation is when Trade Unions were extremely strong, causing cost push inflation.

LR Philips Curve

However, in the long run, the philips curve is perfectly inelastic. I.e Unemployment has no effect on inflation in the LR. This is because the level of unemployment will always return to the Natural Rate of Unemployment in the long run.

In this example, the LRPC curve is shifting left. This could be because benefits and income taxes were reduced (supply side policy).

Natural Rate of Unemployment

• Where unemployment will always return to in the LR.
• LRPC sits at NRU.
• Unemployment below NRU is made up of voluntary unemployment.

To reduce NRU you must decrease voluntary unemployment.

Demand side policies in the LR

In order to see the effect of demand side policies on the

• A -> B
  • Government seeks to reduce unemployment via demand policies, such as lowering IR
  • Unemployment reduces from 5% -> 3%
  • But inflation raises to 4% due to demand-pull inflation / tightening of the labour market
• B -> C
  • Firms and Workers realise they are falling for money illusion
  • In real terms they are no better off than not working / firms not making real profits
  • Firms reduce their number of staff, workers return to benefits
  • Unemployment returns to 5%
  • However, now expectations of 4% are built into the economy
    • Firms keep raising prices
    • Workers demand pay raises
  • So 4% inflation stays, at the original rate of unemployment