Lecture on Short Run and Long Run Phillips Curve

Introduction

• Named after economist Bill Phillips.
• Observed an inverse relationship between inflation and unemployment in the UK during the 1950s.
• Key Observation: High inflation correlates with low unemployment and vice versa.

Short Run Phillips Curve

• Reflects the inverse relationship between inflation and unemployment in the short term.
• Economic Conditions:
  • Strong Economy: High inflation, low unemployment.
  • Weak Economy: Low inflation, high unemployment.

Breakdown in the 1970s

• Stagflation: High inflation and high unemployment simultaneously.
• Led economists to reconsider the Phillips Curve as a short-run phenomenon.

Long Run Phillips Curve

• Represents the natural rate of unemployment at full employment.
• Visualized as a vertical line indicating that unemployment is stable regardless of inflation.
• Full Employment: Does not mean zero unemployment but a sustainable rate.
• Example: Natural rate of unemployment is 4% with 1% inflation.

Aggregate Demand and Aggregate Supply Model

Typical Axes

• Horizontal Axis: Real GDP.
• Vertical Axis: Price level.

Curves

• Aggregate Demand Curve: Downward sloping.
• Short Run Aggregate Supply Curve: Upward sloping, reacts to price levels.
• Long Run Aggregate Supply Curve: Vertical, represents full employment output.

Full Employment Output

• Intersection of Long Run Aggregate Supply and Real GDP axis.
• Example: $50 billion for a small economy.

Impact of Demand Shock

• Government Stimulus: Shifts aggregate demand curve to the right.
• Result: New equilibrium above full employment output.
  • Example: GDP increases from $50 billion to $60 billion.
  • Effects: Unemployment decreases, inflation increases.

Short Run Effects

• Economy operates above potential on the short run Phillips curve.
• Example: Unemployment at 2%, inflation at 3%.

Long Run Effects

• Workers renegotiate contracts due to higher prices.
• Shift: Short run aggregate supply curve shifts left.
• Return to full employment output at a higher price level.

Shift in Short Run Phillips Curve

• Cause: Increased inflation expectations and wage negotiations.
• Effect: Entire curve shifts right.
  • Higher unemployment at a given inflation rate.
  • Example: Inflation remains at 3% with natural unemployment rate.

Conclusion

• The Phillips curves help to understand the relationship between inflation and unemployment in varying economic conditions.
• Acknowledge factors such as demand shocks and wage negotiations that can shift these curves over time.