Notes on the Short-Run Phillips Curve

Introduction to the Phillips Curve

• The Phillips Curve illustrates the relationship between inflation and unemployment.
• It is useful for understanding demand-pull and cost-push inflation and long-term equilibrium using classical models.
• While it's unlikely to receive specific exam questions on it, it can substantiate points in essays regarding inflation and unemployment conflicts.

Historical Context

• The concept was introduced by A.W. Phillips, a New Zealand economist, in the late 1950s and early 1960s.
• He conducted a correlation analysis between wage growth and unemployment over a century.
• Resulted in a downward-sloping curve representing the inverse relationship between wage growth and unemployment:
  • Low unemployment = rising wages (high demand for workers)
  • High unemployment = falling wages (more workers available)

Transition to Inflation Rate

• Economists replaced wage growth with inflation rate in the curve:
  • In the 1960s, wage changes often directly influenced inflation rates.
• The curve reflects the trade-off between unemployment and inflation:
  • Lower unemployment leads to higher inflation and vice versa.

Short-Run Phillips Curve (SRPC)

• SRPC shows the relationship between inflation and unemployment:
  • Low unemployment = high inflation
  • Low inflation = high unemployment
• Represents a conflict for policymakers:
  • To achieve low unemployment, inflation may rise.
  • To keep inflation low, unemployment may rise.

Classical Model Interaction

• The conflict illustrated by the SRPC is tied to shifts in aggregate demand (AD):
  • AD Shift Right: Increases growth, decreases unemployment, but raises inflation.
  • AD Shift Left: Decreases growth, increases unemployment, but lowers inflation.
• Movement along the SRPC occurs with shifts in AD:
  • Right shift moves up the curve (higher inflation, lower unemployment).
  • Left shift moves down the curve (lower inflation, higher unemployment).

Monetarist Adaptation

• Monetarists, led by Milton Friedman, criticized the basic Phillips Curve for not accounting for stagflation (high inflation and high unemployment).
• Suggested that the SRPC can shift:
  • Negative supply-side shocks (e.g., rising oil prices) shift SRPC right (higher inflation, higher unemployment).
  • Positive supply-side shocks (e.g., falling oil prices) shift SRPC left (lower inflation, lower unemployment).

Stagflation Representation

• Stagflation can now be represented on the SRPC:
  • Negative supply shock leads to simultaneous increases in inflation and unemployment.
• Adapting the model allows for a better understanding of cost-push inflation.

Limitations of the Phillips Curve

• Despite adaptations, the SRPC does not reflect long-term equilibrium.
• The classical model explains how the economy returns to full employment, which the SRPC does not address.
• Further adaptations are necessary for a long-run Phillips Curve representation.

Conclusion

• The Phillips Curve is essential for understanding inflation and unemployment interactions.
• It is particularly useful for illustrating the demand for inflation and the conflict between inflation and unemployment.
• The next discussion will focus on deriving the long-run Phillips Curve.