Long-run Phillips curve

Definition

The long-run Phillips curve illustrates the relationship between inflation and unemployment in an economy over a long period. Unlike the short-run Phillips curve, which suggests a trade-off between inflation and unemployment, the long-run version indicates that this trade-off does not exist in the long run, as the economy adjusts to natural rates of unemployment and expected inflation.

5 Must Know Facts For Your Next Test

1. In the long run, the long-run Phillips curve is vertical at the natural rate of unemployment, indicating that no trade-off exists between inflation and unemployment.
2. The position of the long-run Phillips curve can shift due to changes in factors such as supply shocks or changes in inflation expectations.
3. If inflation expectations rise, the long-run Phillips curve shifts to the right, leading to a higher natural rate of unemployment without affecting inflation.
4. Central banks often aim for low and stable inflation to anchor inflation expectations, which helps maintain the long-run Phillips curve at its original position.
5. In the context of economic policy, understanding the long-run Phillips curve helps policymakers avoid the pitfalls of trying to exploit the short-term trade-off between inflation and unemployment.

Review Questions

• How does the long-run Phillips curve differ from the short-run Phillips curve in terms of inflation and unemployment relationships?
  • The long-run Phillips curve differs from the short-run Phillips curve primarily in that it illustrates a vertical relationship at the natural rate of unemployment, meaning there is no trade-off between inflation and unemployment over time. In contrast, the short-run Phillips curve suggests that there is an inverse relationship between these two variables, where lower unemployment can be achieved at the cost of higher inflation. Over time, as expectations adjust and markets clear, economies tend to revert to this natural rate without any lasting effects from inflationary policies.
• Discuss how shifts in inflation expectations can impact the position of the long-run Phillips curve.
  • Shifts in inflation expectations can significantly affect the position of the long-run Phillips curve. If businesses and consumers expect higher future inflation, they may adjust their pricing and wage-setting behavior accordingly. This increase in expected inflation causes the long-run Phillips curve to shift to the right, indicating a higher natural rate of unemployment. Consequently, policymakers must understand these shifts to effectively manage economic stability and prevent persistent inflation or deflation.
• Evaluate the implications of the long-run Phillips curve for monetary policy decisions in an economy experiencing persistent high inflation.
  • The implications of the long-run Phillips curve for monetary policy are critical when dealing with persistent high inflation. In such a scenario, policymakers must recognize that attempts to reduce unemployment by increasing inflation may only be effective in the short run. As expectations adjust, they risk shifting the long-run Phillips curve upward, leading to a higher natural rate of unemployment without curbing inflation. Therefore, central banks may need to prioritize stabilizing inflation expectations through tighter monetary policy to restore balance while avoiding significant increases in unemployment.

Related terms

Short-run Phillips curve: The short-run Phillips curve shows an inverse relationship between inflation and unemployment, suggesting that higher inflation can lead to lower unemployment 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, incorporating frictional and structural unemployment but not cyclical unemployment.

Expectations-augmented Phillips curve: The expectations-augmented Phillips curve incorporates the role of inflation expectations, showing how actual inflation can deviate from expected inflation in both the short run and long run.