# Unemployment and inflation

> IB Economics SL · IB DP Economics SL
> Source: https://www.owlsprep.com/study/ib-economics-sl-u3-unemployment-and-inflation/

This sub-topic explores the historical and theoretical relationship between unemployment and inflation, covering the Phillips curve framework and its macroeconomic policy implications. You will learn how this relationship differs between the short run and long run.

**Prerequisites:** [Measurement of unemployment and inflation](https://www.owlsprep.com/study/ib-economics-sl-u3-measuring-unemployment-inflation/); [Aggregate supply and demand](https://www.owlsprep.com/study/ib-economics-sl-u2-aggregate-supply-demand/)

## Learning objectives

- Explain the theoretical relationship between unemployment and inflation
- Distinguish between short-run and long-run Phillips curve frameworks
- Analyze causes of shifts in the Phillips curve
- Evaluate policy implications of the Phillips curve model
- Calculate and interpret the misery index

## The Original Phillips Curve Relationship

**Original Phillips Curve** — An inverse statistical relationship observed between the rate of inflation and the rate of unemployment, originally interpreted as a stable permanent trade-off for policymakers.

*Example:* Lower unemployment is associated with higher inflation, and lower inflation is associated with higher unemployment.

A.W. Phillips first documented this inverse relationship in 1958 using UK data. Keynesian economists initially accepted this as a permanent trade-off, arguing policymakers could choose a point on the curve that matched their policy priorities.

**Worked example:** A hypothetical economy has two observed equilibrium points: (1% inflation, 6% unemployment) and (4% inflation, 3% unemployment). What trade-off does this data imply?

1. 1. Plot the points on a graph with inflation on the y-axis and unemployment on the x-axis. A line connecting the two points slopes downward, confirming an inverse relationship.
2. 2. To reduce unemployment from 6% to 3%, the economy must accept an increase in inflation from 1% to 4%.
3. 3. The implied trade-off is that lower unemployment comes at the cost of higher inflation, and vice versa, according to the original Phillips framework.

## Short-Run vs Long-Run Phillips Curve

The 1970s stagflation (high inflation + high unemployment) disproved the idea of a permanent trade-off. Friedman and Phelps developed the modern model that distinguishes between short-run and long-run outcomes based on inflation expectations.

**Long-Run Phillips Curve (LRPC)** — A vertical line at the natural rate of unemployment (NRU), showing that there is no permanent trade-off between inflation and unemployment in the long run. Any change in inflation leaves unemployment unchanged at the NRU.

*Notation:* LRPC

*Example:* If inflation rises from 2% to 5%, the long-run unemployment rate stays at the original 4% NRU.

The Short-Run Phillips Curve (SRPC) is downward sloping because expectations of inflation are fixed in the short run. When actual inflation exceeds expected inflation, real wages fall, firms hire more workers, and unemployment falls temporarily. Once workers adjust their inflation expectations, unemployment returns to the NRU.

**Worked example:** An economy starts at equilibrium with 2% expected inflation and 4% unemployment (the NRU). The central bank increases aggregate demand to push actual inflation to 4%. What happens to unemployment in the short run and long run?

1. 1. Short run: Actual inflation (4%) > expected inflation (2%). Real wages fall, so firms increase output and employment. Unemployment falls to 2% at the new short-run equilibrium on the original SRPC.
2. 2. Over time, workers observe higher inflation and adjust their inflation expectations to 4%. They demand higher nominal wages to restore real wages.
3. 3. Long run: Higher nominal wages increase firm costs, so firms reduce employment back to original levels. Unemployment returns to 4% (the NRU), but inflation is now permanently higher at 4% on a new, shifted SRPC.
4. Conclusion: There is only a temporary short-run trade-off; no permanent trade-off exists in the long run.

> **tip**
>
> Always label axes correctly: inflation on the y-axis, unemployment on the x-axis. Swapping axes is a common exam error that loses marks.

## Shifts of the Phillips Curve

The SRPC shifts when either expected inflation changes or the natural rate of unemployment changes. Changes in aggregate demand cause movements along a fixed SRPC, not shifts.

- An increase in expected inflation shifts the SRPC upward
- A decrease in expected inflation shifts the SRPC downward
- An increase in the NRU shifts both SRPC and LRPC rightward
- A decrease in the NRU shifts both SRPC and LRPC leftward

> **info**
>
> Negative supply shocks (e.g. higher oil prices, supply chain disruptions) cause stagflation by shifting the SRPC (and LRPC, if the NRU increases) rightward, leading to higher inflation and higher unemployment simultaneously.

**Worked example:** What happens to the Phillips curve after a sustained increase in the natural rate of unemployment from 4% to 5%?

1. 1. The LRPC shifts rightward from 4% unemployment to 5% unemployment on the x-axis.
2. 2. The SRPC also shifts rightward to match the new higher natural rate of unemployment.
3. 3. At any given inflation rate, equilibrium unemployment is now 1 percentage point higher than before, which matches the definition of stagflation.

## Policy Implications and the Misery Index

The Phillips curve model shapes how economists recommend macroeconomic policy: Keynesian economists argue some long-run trade-off exists, supporting active demand management to reduce unemployment. Monetarist and new classical economists argue there is no long-run trade-off, so policy should focus on low inflation and supply-side reforms to reduce the NRU.

**Misery Index** — A simple measure of economic hardship that combines inflation and unemployment into a single metric. Higher values indicate greater economic distress for the average population.

**Worked example:** Calculate the misery index for an economy with 3.5% inflation and 6.5% unemployment. Interpret the result.

1. 1. Use the formula for the misery index:
2. $$\text{Misery Index} = \text{Inflation Rate} + \text{Unemployment Rate}$$
3. 2. Substitute the values:
4. $$\text{Misery Index} = 3.5 + 6.5 = 10$$
5. 3. Interpretation: A value of 10 is considered high economic distress; values below 5 are low distress, 5-10 are moderate.

## Common pitfalls

- **Wrong:** Claiming there is a permanent trade-off between inflation and unemployment in the long run
  - Why it fails: The IB syllabus follows the modern Friedman-Phelps model that rejects a permanent long-run trade-off
  - Correct: State that the trade-off is only temporary in the short run, with a vertical LRPC at the natural rate of unemployment
- **Wrong:** Swapping the axes on a Phillips curve diagram
  - Why it fails: Examiners explicitly mark this as a diagram error, even if your written explanation is correct
  - Correct: Always place inflation on the vertical y-axis and unemployment on the horizontal x-axis
- **Wrong:** Confusing shifts of the SRPC with movements along the SRPC
  - Why it fails: Changes in aggregate demand cause movement along a fixed SRPC; only changes in expectations or the NRU shift the curve
  - Correct: Use the rule: demand changes = movement along the curve; supply/expectations changes = shift the curve
- **Wrong:** Treating the LRPC as fixed even when the natural rate of unemployment changes
  - Why it fails: The LRPC is only fixed if the NRU is constant; structural changes or supply-side policies change the NRU, so the LRPC shifts
  - Correct: Always shift the LRPC at the same time as the SRPC when the natural rate of unemployment changes

## Cheatsheet

| Concept | Shape | Key Property |
| --- | --- | --- |
| Original Phillips Curve | Downward sloping | Inverse permanent trade-off |
| Short-Run Phillips Curve | Downward sloping | Inverse temporary trade-off |
| Long-Run Phillips Curve | Vertical at NRU | No permanent trade-off |
| Increase in expected inflation | SRPC shifts up | Same unemployment, higher inflation |
| Increase in NRU | SRPC + LRPC shift right | Higher inflation + higher unemployment (stagflation) |
| Misery Index | N/A | Inflation + Unemployment = higher = more distress |

## What's next

Understanding the relationship between unemployment and inflation is the foundation for evaluating all macroeconomic policy, which is a core exam-weighted topic in IB Economics SL. This framework is used to explain how policymakers respond to recessions, stagflation, and supply shocks, and it appears in nearly every exam paper 1 and 2 section. Mastery of this topic will help you build strong evaluation arguments for policy questions, which make up a large share of your final exam marks. Next, you can extend your knowledge by exploring how different types of policy are designed to address unemployment and inflation.

- [Supply-side policies](https://www.owlsprep.com/study/ib-economics-sl-u3-supply-side-policies/)
- [Income distribution and equity](https://www.owlsprep.com/study/ib-economics-sl-u3-income-distribution-and-equity/)
- [Fiscal and Monetary Policy](https://www.owlsprep.com/study/ib-economics-sl-u3-fiscal-and-monetary-policy/)

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