# The Phillips Curve

> Economics · CIE A-Level
> Source: https://www.owlsprep.com/study/cie-9708-u5-the-phillips-curve/

This sub-topic explains the historical inverse relationship between inflation and unemployment, distinguishes between short-run and long-run versions of the curve, and explores its implications for government macroeconomic policy intervention.

**Prerequisites:** [Aggregate Demand and Aggregate Supply Framework](https://www.owlsprep.com/study/cie-9708-u4-aggregate-demand-aggregate-supply/); [Inflation and Unemployment Measurement](https://www.owlsprep.com/study/cie-9708-u4-inflation-unemployment/)

## Learning objectives

- Explain the inverse relationship between inflation and unemployment in the short run
- Distinguish between short-run and long-run versions of the Phillips curve
- Identify causes of shifts in the Phillips curve
- Evaluate policy implications of the Phillips curve framework for governments
- Define and explain the concept of NAIRU

## The Original Short-Run Phillips Curve

**Short-Run Phillips Curve (SRPC)** — A downward-sloping curve showing the inverse relationship between the rate of inflation and the rate of unemployment in the short run, when nominal wages are sticky and inflation expectations are held constant.

*Example:* A 2% fall in unemployment is typically associated with a 1.5% rise in inflation, ceteris paribus.

A.W. Phillips originally documented this inverse relationship in UK wage growth and unemployment data from 1861 to 1957. The relationship exists because higher aggregate demand increases output, reduces unemployment, and pushes up wages and prices, creating a short-run trade-off for policymakers.

**Worked example:** An economy has an SRPC given by $\pi = 6 - 0.5u$, where $\pi$ is inflation (%) and $u$ is unemployment (%). Calculate inflation when unemployment is 4%, and unemployment when inflation is 3%.

1. Step 1: Substitute $u = 4$ into the SRPC equation:
2. $$\pi = 6 - 0.5(4) = 6 - 2 = 4$$
3. Inflation when unemployment is 4% is 4%.
4. Step 2: Substitute $\pi = 3$ into the SRPC equation to solve for $u$:
5. $$3 = 6 - 0.5u \implies 0.5u = 3 \implies u = 6$$
6. Unemployment when inflation is 3% is 6%, confirming the inverse relationship: higher inflation corresponds to lower unemployment.

> **Exam tip:** Always label both axes of your Phillips curve diagram (inflation on vertical, unemployment on horizontal) to earn full marks in exam questions.

## Shifts in the Short-Run Phillips Curve

Movements along a fixed SRPC are caused by changes in aggregate demand. The entire SRPC shifts only when there is a change in inflation expectations or a supply-side shock that changes production costs.

> **warning**
>
> An increase in expected inflation or a negative supply shock (like an oil price rise) shifts the SRPC upward/rightward. A fall in expected inflation or positive supply shock shifts it downward/leftward.

**Worked example:** An economy initially has 3% inflation at 5% unemployment on $SRPC_1$. A global oil price rise adds 2% to inflation at every level of unemployment. What is the new inflation rate at 5% unemployment, and how is this shown on the Phillips curve diagram?

1. Step 1: Identify the type of change: a negative supply shock shifts the entire SRPC, it does not cause a movement along the existing curve.
2. Step 2: Calculate the new inflation rate by adding the shock to the original inflation value:
3. $$\text{New } \pi = 3\% + 2\% = 5\%$$
4. Step 3: Diagrammatically, the entire SRPC shifts up from $SRPC_1$ to $SRPC_2$. At the same 5% unemployment rate, inflation is now 5%, creating stagflation (high inflation and high unemployment).

## Long-Run Phillips Curve and NAIRU

Friedman and Phelps argued that the inverse trade-off between inflation and unemployment is only temporary. In the long run, workers adjust their inflation expectations to match actual inflation, so there is no permanent trade-off.

**Non-Accelerating Inflation Rate of Unemployment (NAIRU)** — The equilibrium rate of unemployment where inflation is stable and there is no upward or downward pressure on inflation. It is equal to the natural rate of unemployment, which includes frictional and structural unemployment.

*Example:* If unemployment falls below NAIRU, inflation will accelerate; if it rises above NAIRU, inflation will fall.

**Worked example:** An economy is initially at NAIRU of 4% unemployment, with stable inflation of 2%. The government uses expansionary policy to reduce unemployment to 3%. Explain what happens to inflation in the long run.

1. Step 1: In the short run, higher unexpected inflation reduces real wages, firms hire more workers, so unemployment falls to 3% along the original SRPC, and inflation rises to 3%.
2. Step 2: Over time, workers adjust their inflation expectations to the new higher 3% inflation, and demand higher nominal wages.
3. Step 3: Higher wages increase firms' costs, shifting the SRPC upward. Unemployment returns to the NAIRU of 4%, but inflation is now permanently higher at 3%.
4. Step 4: This confirms that the LRPC is vertical at NAIRU, with no long-run trade-off between inflation and unemployment.

> **Exam tip:** Always explicitly label the NAIRU on the horizontal axis when drawing the LRPC, this is a common required marking point in CIE exams.

## Policy Implications of the Phillips Curve

The original SRPC suggested governments could choose a stable combination of inflation and unemployment: accept higher inflation for permanently lower unemployment, or vice versa. The LRPC framework overturned this conclusion: expansionary demand policy can only temporarily reduce unemployment, and will only result in permanently higher inflation in the long run. To permanently reduce equilibrium unemployment, governments need supply-side policies that lower the NAIRU.

**Worked example:** A government wants to permanently reduce equilibrium unemployment from 5% to 4%. Should it use expansionary fiscal policy or supply-side policies? Explain using the Phillips curve model.

1. Step 1: Expansionary fiscal policy increases aggregate demand, which reduces unemployment temporarily along the existing SRPC, leading to higher inflation.
2. Step 2: In the long run, inflation expectations adjust, the SRPC shifts upward, and unemployment returns to the original 5% NAIRU, but with higher inflation.
3. Step 3: Supply-side policies (like reducing unemployment benefits, deregulating labour markets) reduce frictional and structural unemployment, which lowers the NAIRU.
4. Step 4: This shifts the LRPC leftward to 4% unemployment, and also shifts the SRPC leftward, resulting in lower unemployment and stable inflation. Supply-side policy is the correct approach.

## Common pitfalls

- **Wrong:** Confusing movements along the SRPC with shifts of the SRPC
  - Why it fails: Students often misclassify changes caused by aggregate demand shifts as curve shifts, or supply shocks as movements along the curve
  - Correct: Remember: Aggregate demand changes cause movements along a fixed SRPC; changes in inflation expectations or aggregate supply cause shifts of the entire SRPC
- **Wrong:** Claiming expectations are constant in the long run, so the LRPC is vertical
  - Why it fails: This is the opposite of the correct reasoning for a vertical LRPC
  - Correct: LRPC is vertical because expectations fully adjust to actual inflation in the long run, eliminating the short-run trade-off
- **Wrong:** Stating NAIRU equals zero unemployment
  - Why it fails: NAIRU is the equilibrium unemployment rate, which still includes frictional and structural unemployment
  - Correct: NAIRU equals the natural rate of unemployment, which is always positive even when the economy is at full employment
- **Wrong:** Drawing the vertical LRPC through the origin of the diagram
  - Why it fails: NAIRU is a positive value, so LRPC is never located at the origin
  - Correct: Always plot the positive value of NAIRU on the horizontal axis first, then draw the vertical LRPC through that point

## Cheatsheet

| Concept | Shape | Causes of change | Key implication |
| --- | --- | --- | --- |
| Short-run Phillips Curve | Downward-sloping | Movement: AD change; Shift: expectations/supply shocks | Short-run trade-off between inflation and unemployment |
| Long-run Phillips Curve | Vertical at NAIRU | Shift: change in natural rate of unemployment | No permanent long-run trade-off |
| Negative supply shock | Upward/rightward SRPC shift | Higher production costs (e.g. oil rise) | Causes stagflation: higher inflation + higher unemployment |
| Supply-side policy to cut unemployment | Leftward shift of SRPC + LRPC | Lower frictional/structural unemployment | Permanently lower equilibrium unemployment |

## What's next

Understanding the Phillips curve is critical for evaluating the effectiveness of government macroeconomic policies, particularly the trade-off between demand-management and supply-side intervention. It forms the foundation for analyzing inflation targeting, the most common policy framework used by modern central banks. The model also helps explain the 1970s stagflation that challenged traditional Keynesian demand management, and clarifies why permanent unemployment reduction requires supply-side reform. Next, you can explore how these concepts apply to real-world policy design.

- [Supply-side Macroeconomic Policies](https://www.owlsprep.com/study/cie-9708-u5-supply-side-policies/)
- [Macroeconomic policy evaluation](https://www.owlsprep.com/study/cie-9708-u5-macroeconomic-policy-evaluation/)
- [Economic Development](https://www.owlsprep.com/study/cie-9708-u6-overview/)

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