A new picture of the same story
In the AD–AS model, an increase in AD raises real output and the price level. More output needs more workers, so unemployment falls. A faster-rising price level means higher inflation. So in the short run, lower unemployment tends to come with higher inflation, and higher unemployment with lower inflation.
The Phillips curve model plots this relationship directly. It uses two axes you already know:
- Vertical axis: the inflation rate (%).
- Horizontal axis: the unemployment rate (%).
Each point on the graph is one combination of inflation and unemployment.
The short-run Phillips curve (SRPC)
The short-run Phillips curve (SRPC) slopes downward. It shows the short-run trade-off: policymakers can push unemployment down only by accepting higher inflation, or push inflation down only by accepting higher unemployment.
Why the trade-off exists only in the short run: some wages and prices are fixed for a while (the same sticky input prices that make SRAS slope upward). When AD rises, firms can sell more at higher prices while many costs stay put, so they hire more workers.
The economy is always somewhere on its current SRPC. If the economy appears to jump to a point off the curve, it means the SRPC has shifted.
The long-run Phillips curve (LRPC)
In the long run, wages and prices fully adjust, output returns to full-employment output and unemployment returns to the natural rate (frictional plus structural unemployment). This happens whatever the inflation rate. So the long-run Phillips curve (LRPC) is a vertical line at the natural rate of unemployment. It matches the vertical LRAS curve: there is no long-run trade-off between inflation and unemployment.
Equilibrium and gaps on the graph
- Long-run equilibrium is where the SRPC crosses the LRPC. Unemployment equals the natural rate.
- A point on the SRPC to the left of the LRPC has unemployment below the natural rate. Real output is above full-employment output: an inflationary gap.
- A point on the SRPC to the right of the LRPC has unemployment above the natural rate. Real output is below full-employment output: a recessionary gap.
| AD–AS model | Phillips curve model |
|---|---|
| Vertical LRAS at full-employment output | Vertical LRPC at the natural rate of unemployment |
| Output above full employment (inflationary gap) | Point on the SRPC to the left of the LRPC |
| Output below full employment (recessionary gap) | Point on the SRPC to the right of the LRPC |
| AD shifts (SRAS fixed) | Movement along the SRPC |
| SRAS shifts | The SRPC shifts in the opposite direction (SRAS left → SRPC right) |
| LRAS shifts because the natural rate changes | LRPC shifts |
Our fictional economy: Valdoria
Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). All data are fictional.
- Natural rate of unemployment: 5.0%. Labour force: 25.0 million. Full-employment output: VD 840 billion.
- In long-run equilibrium, inflation is 2% a year.
- Valdoria’s current SRPC (SRPC₁) passes through these points:
| Unemployment rate | 3% | 4% | 5% | 6% | 7% |
|---|---|---|---|---|---|
| Inflation rate | 6% | 4% | 2% | 0% | −2% |
Worked example 1: a demand shock, short run and long run
Question. Valdoria starts at point A: unemployment 5%, inflation 2%.
(a) Explain why A is a long-run equilibrium. (b) Households become more optimistic and consumer spending rises. Using the table, identify the new short-run point B if unemployment falls to 4%. Describe the change from A to B. (c) Is B an inflationary or a recessionary gap? How many people fewer are unemployed than at the natural rate? (d) Explain what happens in the long run if there is no policy action, and identify the long-run point. (e) A year earlier, a fall in business investment had moved Valdoria to unemployment of 6%. Identify the inflation rate and the type of gap.
(a) At A, unemployment equals the natural rate (5%). A lies on both SRPC₁ and the LRPC, at their intersection.
(b) Higher consumer spending is a demand shock: AD shifts right. The economy moves up and to the left along SRPC₁ to B: unemployment 4%, inflation 4%. Unemployment fell by 1 percentage point and inflation rose by 2 percentage points. The SRPC itself has not moved.
(c) B is to the left of the LRPC, so it is an inflationary gap. Unemployment is 1 percentage point below the natural rate: 0.01 × 25.0 million = 0.25 million fewer people unemployed.
(d) At B, workers and firms find that prices are rising faster than they expected. When contracts are renewed, nominal wages rise. In the AD–AS model, SRAS shifts left; in the Phillips curve model, the SRPC shifts right. Output falls back to full employment and unemployment returns to 5%. Because people now expect inflation of about 4%, the new curve SRPC₂ crosses the LRPC at point E: unemployment 5%, inflation 4%. The short-run gain in employment has gone, and inflation is higher than at the start.
(e) From the table, unemployment of 6% on SRPC₁ means inflation of 0%. The point is to the right of the LRPC: a recessionary gap.
Check. All the demand-shock points (A, B and the 6% point) lie on the same SRPC₁. Only in the long-run adjustment of part (d) did the curve move.
Supply shocks shift the SRPC
A supply shock shifts SRAS, so it changes inflation and unemployment in the same direction. That cannot happen along one downward-sloping curve, so the SRPC shifts.
- Adverse (negative) supply shock, such as a sharp rise in energy prices: SRAS shifts left, output falls and the price level rises. Unemployment and inflation both rise (stagflation). The SRPC shifts right (up).
- Favourable (positive) supply shock, such as a sharp fall in energy prices: SRAS shifts right. Unemployment and inflation both fall. The SRPC shifts left (down).
Worked example 2: an adverse supply shock
Question. Valdoria is back at A (5%, 2%) on SRPC₁. The world price of oil, a key input, jumps. The new SRPC₃ passes through these points:
| Unemployment rate | 4% | 5% | 6% | 7% |
|---|---|---|---|---|
| Inflation rate | 8% | 6% | 4% | 2% |
(a) The economy moves to unemployment of 6%. Identify the new point D and describe how it differs from A. (b) Explain why this is shown as a shift of the SRPC, not a movement along it. (c) If policymakers use expansionary demand policy to bring unemployment back to 5%, what inflation rate results in the short run? If they use contractionary demand policy to bring inflation back to 2%, what unemployment rate results? (d) What happens in the long run if there is no policy response and oil prices return to normal?
(a) D: unemployment 6%, inflation 4% on SRPC₃. Compared with A, unemployment is 1 percentage point higher and inflation is 2 percentage points higher: stagflation.
(b) Both inflation and unemployment rose. On SRPC₁, higher unemployment comes with lower inflation, so D cannot lie on SRPC₁. The higher input cost shifted SRAS left, which shifts the SRPC right.
(c) Demand policy moves the economy along SRPC₃. Expansionary policy to 5% unemployment gives inflation of 6%. Contractionary policy to 2% inflation gives unemployment of 7%. A supply shock leaves policymakers with a hard choice: fixing one problem makes the other worse in the short run.
(d) As the oil price returns to normal (and, with high unemployment, nominal wages stop rising so fast), SRAS shifts back right. The SRPC shifts back left to SRPC₁, and the economy returns towards A (5%, 2%).
Check. At 2% inflation, SRPC₁ is at 5% unemployment and SRPC₃ is at 7%. The whole curve has moved; the LRPC has not moved, because the oil shock did not change the natural rate.
What shifts the LRPC
The LRPC sits at the natural rate of unemployment, so anything that changes the natural rate shifts the LRPC. Demand shocks and temporary supply shocks do not.
- Natural rate falls → LRPC shifts left. Example: a new national job-matching website helps Valdorians find suitable jobs faster, cutting frictional unemployment. If the natural rate falls from 5.0% to 4.5%, the LRPC moves to 4.5%.
- Natural rate rises → LRPC shifts right. Example: new technology makes many workers’ skills obsolete, raising structural unemployment for a long period.
A lower natural rate also means more people working at full employment, so the LRAS curve shifts right at the same time.
Common misconceptions
- “A demand shock shifts the SRPC.” It moves the economy along the SRPC. Only supply shocks (and the long-run adjustment of wages and expectations) shift the SRPC.
- “SRAS shifts left, so SRPC shifts left.” They move in opposite directions: SRAS left means SRPC right.
- “The LRPC is at 0% unemployment.” It is vertical at the natural rate.
- “Points to the left of the LRPC are recessionary.” Left means unemployment is below the natural rate: an inflationary gap.
- Swapping the axes. Inflation on the vertical axis, unemployment on the horizontal.
- “Policy can keep unemployment below the natural rate permanently.” Only in the short run. In the long run the SRPC shifts and unemployment returns to the natural rate, with higher inflation.
- “An oil shock shifts the LRPC.” A temporary supply shock shifts the SRPC; the LRPC moves only if the natural rate changes.
Where this leads
Topic 5.3 explains what causes inflation to persist in the long run: continue with the money growth and inflation study guide. The Phillips curve gives you a second graph for the policy actions in Topic 5.1: an expansionary policy mix moves the economy up and to the left along the SRPC.
Now try the practice questions, then use the revision notes and the checklist to consolidate.
Quick questions
Can the economy be off the short-run Phillips curve?
No. The economy is always somewhere on its current SRPC. When something seems to push it off, the SRPC itself has shifted.
Which axis is which?
The inflation rate goes on the vertical axis and the unemployment rate on the horizontal axis. Both are percentages.