The Phillips Curve — AP Macroeconomics Study Guide

For: AP Macroeconomics candidates sitting AP Macroeconomics.

Covers: Short-run Phillips curve (SRPC), long-run Phillips curve (LRPC), the inflation-unemployment tradeoff, expected inflation, supply shocks, shift factors for both curves, and the relationship between the Phillips Curve and the AD-AS model.

You should already know: Aggregate demand-aggregate supply (AD-AS) model and how shifts change price level and output. Natural rate of unemployment (NRU) and its definition. Demand-pull vs. cost-push inflation.

A note on the practice questions: All worked questions in the "Practice Questions" section below are original problems written by us in the AP Macroeconomics style for educational use. They are not reproductions of past College Board / Cambridge / IB papers and may differ in wording, numerical values, or context. Use them to practise the technique; cross-check with official mark schemes for grading conventions.

1. What Is The Phillips Curve?

The Phillips Curve is a core macroeconomic model that describes the relationship between an economy’s inflation rate and unemployment rate. Originally documented by A.W. Phillips and later adapted for macroeconomic policy analysis by Samuelson, Solow, Friedman, and Phelps, it is a required topic in the AP Macroeconomics Course and Exam Description (CED) for Unit 4 (Financial Sector). It makes up approximately 10-15% of the unit’s exam weight, and appears regularly in both multiple-choice questions (MCQ) and as a core component of free-response questions (FRQ) on the AP exam.

Standard notation for the model places the unemployment rate ($u$) on the horizontal x-axis and the inflation rate ($\pi$) on the vertical y-axis. The Phillips Curve is directly linked to the AD-AS model: changes in aggregate demand that move the economy along the short-run aggregate supply (SRAS) curve correspond to movements along the short-run Phillips Curve, while changes that shift SRAS shift the short-run Phillips Curve. The model is central to evaluating tradeoffs faced by policymakers when implementing monetary or fiscal policy.

2. Short-Run Phillips Curve (SRPC)

The Short-Run Phillips Curve (SRPC) illustrates the inverse relationship between inflation and unemployment that holds in the short run, when nominal wages and inflation expectations are fixed. The intuition for this inverse relationship comes directly from the AD-AS model: an increase in aggregate demand raises output and employment, reducing unemployment, while also pushing up the price level, increasing inflation. A decrease in aggregate demand has the opposite effect: lower inflation, higher unemployment.

The algebraic form of the SRPC is written as: $$\pi ={\pi }^e-\alpha (u-u_n)$$ Where $\pi$ = actual inflation rate, ${\pi }^e$ = expected inflation rate, $u$ = actual unemployment rate, $u_n$ = natural rate of unemployment, and $\alpha$ is a positive constant measuring how responsive inflation is to deviations of unemployment from the natural rate.

Only changes to expected inflation or supply shocks shift the SRPC. An increase in expected inflation or a negative supply shock (e.g., a spike in oil prices) shifts the SRPC upward/right, meaning higher inflation and higher unemployment at every level of actual unemployment. A decrease in expected inflation or a positive supply shock shifts it downward/left. Changes in aggregate demand only cause movements along a fixed SRPC.

Worked Example

Suppose an economy has a natural rate of unemployment of 4%, expected inflation of 3%, and $\alpha =1$. (a) Calculate the actual inflation rate if actual unemployment is 6%. (b) If consumers and workers adjust expected inflation to 5% after a period of rising prices, what is the new actual inflation rate at 6% unemployment? Show your work.

1. First, list all given values for part (a): $u_n=4\%$, ${\pi }^e=3\%$, $\alpha =1$, $u=6\%$.
2. Substitute into the SRPC formula: $\pi =3-1(6-4)=3-2=1\%$.
3. For part (b), update only expected inflation to ${\pi }^e=5\%$; all other values remain constant.
4. Recalculate for the new expected inflation: $\pi =5-1(6-4)=5-2=3\%$.
5. Result: A 2 percentage point increase in expected inflation raises actual inflation by 2 percentage points at the same unemployment rate, which matches an upward/right shift of the SRPC.

Exam tip: If an AP FRQ asks you to graph the SRPC, always explicitly label the axes to earn the point: unemployment on the horizontal, inflation on the vertical — reversing axes is the most common avoidable mistake on this topic.

3. Long-Run Phillips Curve (LRPC)

The Long-Run Phillips Curve (LRPC) describes the relationship between inflation and unemployment when all prices and expectations have fully adjusted. In the long run, workers and firms update their inflation expectations to match actual inflation, so nominal wages adjust to changes in the price level. This means there is no permanent tradeoff between inflation and unemployment in the long run: unemployment always returns to the natural rate of unemployment ($u_n$) regardless of the long-run inflation rate.

As a result, the LRPC is a vertical line at the natural rate of unemployment. This matches the vertical long-run aggregate supply (LRAS) curve in the AD-AS model: LRAS is vertical at potential output, which corresponds to the natural rate of unemployment, so any shift in LRAS leads to an identical direction shift in LRPC. Only changes to the natural rate of unemployment shift the LRPC: if structural unemployment rises from automation, $u_n$ increases, and LRPC shifts right; if job training reduces frictional unemployment, $u_n$ falls, and LRPC shifts left.

Worked Example

An economy starts at long-run equilibrium with a natural rate of unemployment of 5% and long-run inflation of 2%. Policymakers permanently increase aggregate demand to lower unemployment to 3% in the short run. Describe the full long-run adjustment in the Phillips Curve model and find the new long-run equilibrium.

1. Start at the initial equilibrium: the intersection of the initial SRPC (with ${\pi }^e=2\%$) and vertical LRPC at $u=5\%$, $\pi =2\%$.
2. The increase in aggregate demand raises inflation to 4% and lowers unemployment to 3% in the short run: this is a movement up and left along the initial SRPC.
3. Over time, workers observe higher actual inflation and adjust their inflation expectations upward to ${\pi }^e=4\%$, which shifts the SRPC upward/right.
4. The economy returns to the natural rate of unemployment of 5% at the new intersection of the shifted SRPC and unchanged LRPC, with a new long-run inflation rate of 4%.
5. Conclusion: Unemployment returns to its natural rate, but inflation is permanently higher, confirming no long-run tradeoff between inflation and unemployment.

Exam tip: Always remember that the LRPC sits at the same unemployment rate that corresponds to potential output on the AD-AS model. If a question says potential output increases, that means $u_n$ falls, so LRPC shifts left.

4. Distinguishing Movements vs. Shifts

A core AP exam skill is correctly identifying whether a given economic shock causes a movement along the SRPC, a shift of the SRPC, or a shift of the LRPC. The rules for this are consistent across all exam problems: (1) Only changes in aggregate demand cause movements along a fixed SRPC; (2) Only changes in expected inflation or supply shocks shift the SRPC; (3) Only changes to the natural rate of unemployment shift the LRPC. Confusing these categories is the most common reason students lose points on Phillips Curve questions, so memorizing these rules is critical.

Worked Example

A widespread improvement in supply chain efficiency reduces input costs for all domestic firms, and does not change the natural rate of unemployment. How does this shock affect the SRPC and LRPC? Explain your answer.

1. Classify the shock: A reduction in input costs is a positive supply shock, which shifts the SRAS curve right in the AD-AS model.
2. The LRPC only shifts when the natural rate of unemployment changes. The problem explicitly states $u_n$ does not change, so LRPC remains in its original position.
3. A positive supply shock reduces inflation at every level of unemployment, so the SRPC shifts downward/left.
4. At the original unemployment rate, the new equilibrium has lower inflation, which matches the right shift of SRAS: higher output, lower prices, lower inflation, and lower unemployment in the short run. In the long run, the economy returns to $u_n$ at the new lower inflation rate.

Exam tip: If a problem mentions "stagflation" (higher inflation + higher unemployment), this is always caused by a rightward shift of the SRPC, not a movement along the SRPC from a demand change.

5. Common Pitfalls (and how to avoid them)

• Wrong move: Claiming there is a permanent tradeoff between inflation and unemployment, or drawing the LRPC as downward-sloping. Why: Students confuse the short-run inverse relationship with the long-run adjustment of expectations. Correct move: Always draw LRPC as a vertical line labeled at the natural rate of unemployment, and state explicitly that no long-run tradeoff exists.
• Wrong move: Confusing movements along the SRPC with shifts of the SRPC, e.g., saying an increase in aggregate demand shifts SRPC right. Why: Students mix up AD changes (which move along SRAS/SRPC) and SRAS changes (which shift SRAS/SRPC). Correct move: Always check what changed first: AD changes = movement along SRPC; expected inflation/supply shocks = shift of SRPC.
• Wrong move: Reversing the axes, putting inflation on the x-axis and unemployment on the y-axis. Why: Students get used to AD-AS where price is vertical, but mix up variable placement for the Phillips Curve. Correct move: Double-check axes before drawing: unemployment (quantity variable) is horizontal, inflation (price growth variable) is vertical.
• Wrong move: Shifting the LRPC when there is a change in expected inflation. Why: Students assume any change that shifts SRPC also shifts LRPC. Correct move: Only shift LRPC if the problem explicitly mentions a change in structural/frictional unemployment or the natural rate itself.
• Wrong move: Claiming a negative supply shock causes lower unemployment and higher inflation from a movement up the SRPC. Why: Students confuse demand and supply shocks, assuming all inflation increases come from higher AD. Correct move: Negative supply shocks shift SRPC right, leading to higher inflation and higher unemployment (stagflation).
• Wrong move: Shifting LRPC left when potential output decreases. Why: Students match the direction of LRAS shift directly to LRPC without linking output to unemployment. Correct move: Lower potential output means higher natural unemployment, so LRPC shifts right (not left).

6. Practice Questions (AP Macroeconomics Style)

Question 1 (Multiple Choice)

Which of the following shocks will most likely shift the short-run Phillips curve to the right (upward) and leave the long-run Phillips curve unchanged? A) A permanent decrease in the natural rate of unemployment due to new AI-powered job matching technology B) A temporary increase in global coffee prices that raises food service production costs for all domestic firms C) A permanent increase in transfer payments that increases aggregate demand D) A permanent increase in labor productivity that raises long-run potential output

Worked Solution: We can eliminate options one by one. Option A changes the natural rate of unemployment, so it shifts LRPC, so it is incorrect. Option C: an increase in aggregate demand causes a movement along the SRPC, not a shift, so it is incorrect. Option D: a permanent increase in potential output from productivity lowers the natural rate of unemployment, shifting LRPC left, so it is incorrect. Option B: an increase in production costs is a negative supply shock that shifts SRPC right, and it does not change the natural rate of unemployment, so LRPC stays the same. The correct answer is B.

Question 2 (Free Response)

An economy is initially in long-run equilibrium with a natural rate of unemployment of 5% and an inflation rate of 2%. (a) Draw a correctly labeled Phillips Curve graph that shows the initial long-run equilibrium, labeling the equilibrium point A. (b) Suppose the central bank engages in contractionary monetary policy that decreases aggregate demand to lower inflation. On your graph from (a), show the short-run effect of this policy, labeling the new short-run equilibrium point B. Explain what happens to inflation and unemployment in the short run. (c) After the policy, how does the economy adjust in the long run? Show this adjustment on your graph and label the new long-run equilibrium point C. What is the new unemployment rate and new inflation rate in long-run equilibrium?

Worked Solution: (a) Correct graph requirements: x-axis labeled "Unemployment Rate", y-axis labeled "Inflation Rate". Draw a vertical LRPC at 5% unemployment. Draw a downward-sloping SRPC intersecting LRPC at (5%, 2%), labeled as point A. (b) Contractionary monetary policy reduces aggregate demand, leading to lower inflation and higher unemployment in the short run. This causes a movement down and to the right along the original SRPC to point B, where inflation is lower than 2% and unemployment is higher than 5%. In the short run, nominal wages are fixed, so lower price levels reduce firm profits, leading to lower output and higher unemployment. (c) In the long run, workers observe lower actual inflation and adjust their inflation expectations downward. Lower expected inflation shifts the SRPC downward (left) along the unchanged LRPC. The new long-run equilibrium point C is at the intersection of the shifted SRPC and original LRPC. The new long-run unemployment rate returns to the natural rate of 5%, and the new long-run inflation rate is permanently lower than the original 2%.

Question 3 (Application / Real-World Style)

In 2022, an economy had an actual inflation rate of 8%, actual unemployment of 6%, and the natural rate of unemployment was 4%. Expected inflation was 6%, and α = 1. Starting from the SRPC equation, calculate the size of the additional shift in SRPC caused by negative supply shocks beyond the change in expected inflation. Explain what your result means in context.

Worked Solution: First, write the SRPC equation: $$\pi ={\pi }^e-\alpha (u-u_n)$$ Substitute the values given: ${\pi }^e=6\%$, $\alpha =1$, $u=6\%$, $u_n=4\%$: $$\text{Predicted inflation}=6-1(6-4)=4\%$$ Actual inflation is 8%, so the additional shift from negative supply shocks is $8\%-4\%=4\%$. In context, the 4 percentage point additional upward shift of the SRPC reflects the direct impact of negative supply shocks (like energy price increases) that raised inflation beyond what would be expected from just the change in expected inflation and the deviation of unemployment from the natural rate. This matches the observed stagflation of the period, with higher inflation and higher unemployment than would occur from a pure demand shock.

7. Quick Reference Cheatsheet

8. What's Next

Mastering the Phillips Curve is critical for analyzing monetary and fiscal policy, the next core topics in Unit 4 and Unit 5 of AP Macroeconomics. Without understanding the short-run vs. long-run tradeoff between inflation and unemployment, you cannot correctly evaluate the impact of policy actions like central bank interest rate changes or government stimulus spending. The Phillips Curve is also the foundation for understanding the role of inflation expectations in shaping macroeconomic outcomes, a high-weight topic for both AP MCQs and FRQs. Next, you will apply what you learned here to analyze how policy actions affect interest rates, output, and inflation in both the short and long run.

Monetary Policy Fiscal Policy Inflation and Unemployment Aggregate Demand-Aggregate Supply Model