The long-run Phillips curve sheds light on the relationship between inflation and unemployment over extended periods, revealing an intriguing interplay between these key economic factors. Through a clear explanation, accompanied by a diagram that captures its dynamics and shifts, we will uncover the behavior of the long-run Phillips curve, exploring how changes in unemployment impact inflation in the long-term and investigating the factors that drive shifts of the long-run Phillips curve.
What is the Long-Run Phillips Curve?
The long-run Phillips curve is an economic concept that describes the relationship between inflation and unemployment over extended periods. In simple terms, it suggests that in the long run, there is no trade-off between inflation and unemployment.
The long-run Phillips curve represents the idea that, in the long term, there is a vertical relationship between inflation and unemployment, implying that changes in the unemployment rate will not have a sustained effect on inflation. This concept assumes that the economy operates at its natural rate of unemployment, also known as the non-accelerating inflation rate of unemployment (NAIRU).
Imagine an economy where the government tries to lower unemployment rates through expansionary policies, such as increased government spending and reduced interest rates. In the short run, these policies may lead to lower unemployment, but according to the long-run Phillips curve, the unemployment rate would eventually return to its natural level. As businesses adjust their expectations and workers demand higher wages due to inflation, the expansionary policies would only result in higher inflation without creating a lasting decrease in unemployment. This scenario highlights the limits of using monetary or fiscal measures to permanently reduce unemployment without causing inflationary pressures in the long run.
Difference Between Short-Run and Long-Run Phillips Curve
Aside from the obvious difference between the short-run and the long-run Phillips curves in the temporal sense, it's also accurate to state that, unlike the short-run Phillips curve, the Long-Run Phillips Curve considers expected inflation.
Expected inflation is the key difference between the short-run and the long-run Phillips curves because expected inflation can and does lead to changes in the demand for wage rates for households to protect their purchasing power.
If you expect all prices to be 10% higher one year from now than they are today, you would likely do whatever you could to protect your ability to purchase the same amount of goods and services in one year. This is particularly true of essential goods and services such as housing, food, clothes, and transportation.
While the efforts of households to increase their wages in accordance with expected inflation may not always be successful, it is paramount to understand that this phenomenon is precisely what distinguishes the short-run Phillips curve from the long-run Phillips curve. That is, while expected inflation shifts the short-run Phillips curve due to the shock to supply, expected inflation is inherent in the long-run Phillips curve.
Long-Run Phillips Curve Diagram Explained
The key difference between the Short-Run and Long-Run Phillips Curves is inextricably tied to expected inflation and supply shocks.
To understand how expected inflation affects the Long-Run Phillips curve let's look at what happens over the long run when an expansionary policy is put into effect.
Let's consider Figure 1, and let's assume that the current level of inflation is P0 and the unemployment rate is 9%. Let's also assume that the expected inflation level is the actual inflation level at P0.
Fig. 1 - Long-Run Phillips Curve and Expansionary Policy
Now let's assume there's an election coming up, and the incumbent government wants to show that it's doing a good job and decides to use fiscal policy to lower unemployment by one percentage point to 8%.
The incumbent government will apply an expansionary policy, shifting Aggregate Demand to the right, and increasing economic output from Q0 to Q1. We can see that, while the government was successful in decreasing unemployment, it has also increased aggregate price levels from P0 to P1. Since you are now well-versed in the Short-Run Phillips Curve, you know that this will cause a movement along the curve from point A to point B, with unemployment now at 8%, and inflation at P1.
Success right?
Not quite.
You see, while the government successfully increased economic output, and therefore lowered unemployment, in doing so they also increased inflation. Recall that households and workers do account for expected inflation, and now that the actual inflation rate has deviated from its previous rate, workers will endeavor to get wage increases to ensure their purchasing power isn't diminished by asking for COLA wage increases. We know this by another term - a supply shock.
Figure 2 illustrates the effect of the new level of expected inflation on the Short-Run Phillips curve.
Fig. 2 - Long-Run Phillips Curve and Expected Inflation
Since we know that a supply shock will shift aggregate supply to the left, and therefore also shifts the Short-Run Phillips Curve up, we can see by examining Figure 8 that the net effect is a return to 9% unemployment, but at a higher rate of inflation at P2, Q1 and Point C.
If the government persists in trying to lower unemployment rates in anticipation of the upcoming election and re-applies fiscal policy and increases Aggregate Demand once again, they will successfully lower the unemployment rate again to 8%, but at even higher aggregate prices.
Figure 3 illustrates this result by shifting Aggregate Demand once again and shifting the equilibrium to points D, P3 and Q1.
At this point, you know what will happen next. Since expected inflation is higher yet again, a COLA supply shock will re-establish equilibrium at point E with output at Q0 and prices at P4.
As it turns out, the government's efforts to move away from the initial equilibrium unemployment rate of 9% are futile because the Long-Run Phillips curve is perfectly vertical at this non-accelerating inflation rate of unemployment (NAIRU).
Put another way, the only long-run equilibrium available to governments and central banks is at the NAIRU, which is where the Long-Run Phillips curve can be found.
Long-Run Phillips Curve,
The simplest way to think about the Long-Run Phillips Curve, therefore, is to understand that the Long-Run Phillips Curve shows the relationship between unemployment and inflation when expected inflation is also being accounted for over the long term.
As you can see, there are many changes going on in scenarios like the one depicted in Figure 9. You would be right to assume that these changes take time. As a result, it's important to have a naming convention for these periods of adjustment.
As a result, whenever an economy is experiencing a period where unemployment is to the left of the Long-Run Phillips Curve and the NAIRU, these are called inflationary gaps, while periods where unemployment is to the right of the Long-Run Phillips Curve and the NAIRU, are called recessionary gaps,
Points to the left of the Long-Run Phillips Curve equilibrium represent inflationary gaps, while points to the right of the Long-Run Phillips Curve equilibrium represent recessionary gaps.
Long-Run Philips Curve Shifters
In order to think about what might cause a shift in the Long-Run Phillips Curve, it's helpful to think about what might cause a shift in the NAIRU, also known as the Natural Rate of Unemployment.
The StudySmarter explanation for the Natural Rate of Unemployment is an excellent resource to help understand this topic, but in very simple terms, factors that change the Long-Run Phillips Curve, and correspondingly the Natural Rate of Unemployment include:
- Changes in labor force characteristics such as productivity improvements;
- Impacts of labor force institutions such as unions;
- Changes in government policies such as improved employee training, easier job relocation, and changes to the minimum wage.
Long-Run Philips Curve Equation
There is no specific equation for the long-run Phillips curve. Unlike the short-run Phillips curve, which depicts a trade-off between inflation and unemployment, the long-run Phillips curve is represented as a vertical line in graphical form. It suggests that in the long run, changes in the unemployment rate do not have a persistent effect on inflation. Instead, the long-run Phillips curve emphasizes the idea that the economy tends to operate at its natural rate of unemployment, which is determined by structural factors such as demographics, labor market institutions, and productivity.
There is some debate as to the nature of the Long-Run Phillips Curve Equation. While theory posits that the Long-Run Phillips Curve is simply a perfectly vertical line located at the NAIRU, some economists believe there is a slope to the Long-Run Phillips curve.
While that topic is beyond the scope of this level of explanation, it is noteworthy to understand that there is some debate in this area.
Long-Run Phillips Curve - Key takeaways
- The Short-Run Phillips Curve slopes downward to illustrate the trade-off between inflation and unemployment in an economy.
- Both fiscal and monetary policy work in exactly the same manner to create the correlation between unemployment and inflation depicted in the Short-Run Phillips Curve.
- A supply shock is an event that shifts the short-run aggregate supply curve, such as a change in commodity prices, nominal wages, or productivity, and results in a shift in the Short-Run Phillips curve.
- Stagflation is an economic condition where persistently high inflation and high unemployment exist simultaneously.
- The nonaccelerating inflation rate of unemployment, or the NAIRU, is in fact where the Long-Run Phillips Curve exists, and as such is perfectly vertical.
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