Long-Run Phillips Curve

Definition

The long-run Phillips curve illustrates the relationship between inflation and unemployment in an economy when it is operating at full employment. Unlike the short-run Phillips curve, which can show a trade-off between inflation and unemployment, the long-run version is vertical, indicating that in the long run, there is no trade-off between inflation and unemployment; instead, unemployment tends to return to its natural rate regardless of the inflation rate.

5 Must Know Facts For Your Next Test

1. The long-run Phillips curve is based on the concept that in the long run, inflation does not affect unemployment; thus, it is vertical at the natural rate of unemployment.
2. According to economists like Milton Friedman and Edmund Phelps, persistent inflation will eventually lead to an increase in expectations of inflation, shifting the short-run Phillips curve upwards over time.
3. Policies aimed at reducing unemployment through higher inflation will only be effective in the short run; over time, expectations adjust, and the economy returns to its natural rate of unemployment.
4. The long-run Phillips curve indicates that any attempts to keep unemployment below its natural rate will lead to accelerating inflation.
5. Central banks consider the long-run Phillips curve when formulating monetary policy, focusing on maintaining stable prices rather than targeting low unemployment through inflationary measures.

Review Questions

• How does the long-run Phillips curve differ from the short-run Phillips curve in terms of the relationship between inflation and unemployment?
  • The long-run Phillips curve differs significantly from the short-run Phillips curve in that it represents a vertical relationship between inflation and unemployment. In the short run, there can be a trade-off where lower unemployment is associated with higher inflation. However, in the long run, this trade-off disappears as expectations adjust; thus, the economy gravitates toward a natural rate of unemployment regardless of inflation levels.
• What implications does the long-run Phillips curve have for policymakers aiming to manage inflation and unemployment?
  • The long-run Phillips curve implies that policymakers cannot sustainably reduce unemployment below its natural rate through expansionary monetary or fiscal policies. Over time, such efforts will lead to increased inflation without any long-term gains in employment levels. This understanding urges policymakers to focus on structural factors affecting labor markets instead of relying on inflationary measures to manage unemployment.
• Evaluate how adaptive expectations influence the interaction between the short-run and long-run Phillips curves.
  • Adaptive expectations play a crucial role in shaping how individuals and businesses respond to changes in inflation. When people expect future inflation based on past experiences, they adjust their behavior accordingly, leading to shifts in wage negotiations and price-setting. This adjustment process causes the short-run Phillips curve to shift upward over time as actual inflation rises, reinforcing the idea that there is no permanent trade-off between inflation and unemployment as depicted by the vertical long-run Phillips curve. Ultimately, this dynamic underscores why sustained attempts to exploit this trade-off are ineffective in achieving lasting reductions in unemployment.

Related terms

Short-Run Phillips Curve: The short-run Phillips curve depicts an inverse relationship between inflation and unemployment, suggesting that lower unemployment can be achieved at the cost of higher inflation in the short term.

Natural Rate of Unemployment: The natural rate of unemployment is the level of unemployment that exists when the economy is at full employment, determined by structural and frictional factors rather than cyclical ones.

Adaptive Expectations: Adaptive expectations refer to the theory that people's expectations about future inflation are based on past inflation rates, which can influence their economic behavior and wage negotiations.