Resources | Subject Notes | Economics
The Phillips Curve traditionally suggests an inverse relationship between inflation and unemployment. However, this simple relationship has been challenged by the development of the expectations-augmented Phillips curve. This model incorporates the role of expectations in determining the short-run and long-run relationships between inflation and unemployment.
The original Phillips Curve, observed by A.W. Phillips, demonstrated a stable inverse relationship between the rate of wage inflation and the rate of unemployment. This suggested that policymakers could choose a level of unemployment but had to accept a corresponding level of inflation, or vice versa.
The traditional Phillips Curve faced several limitations:
The expectations-augmented Phillips Curve, developed by Milton Friedman and Edmund Phelps, addresses these limitations by incorporating the concept of rational expectations. It posits that individuals form expectations about future inflation based on past inflation and anticipated future economic conditions.
In the short run, the SRPC still shows an inverse relationship between inflation and unemployment. However, this relationship is not stable and can shift due to changes in expectations.
The SRPC is represented by the equation:
$$ \pi^t = \pi^{t-1} + \alpha(u^t - u^{t-1}) + \epsilon^t $$Where:
The slope of the SRPC is determined by the value of $\alpha$.
In the long run, the expectations-augmented Phillips Curve suggests that there is no trade-off between inflation and unemployment. The LRPC is a vertical line at the natural rate of unemployment (also known as the non-accelerating inflation rate of unemployment - NAIRU). This implies that attempts to push unemployment below the NAIRU will only lead to accelerating inflation.
The LRPC is represented by the equation:
$$ \pi = \pi^{LR} $$Where:
The NAIRU is the level of unemployment at which inflation remains constant. It reflects the structural characteristics of the economy, such as labor market rigidities and the efficiency of the economy.
Concept | Description |
---|---|
Short-Run Phillips Curve (SRPC) | Inverse relationship between inflation and unemployment. The slope can shift with changes in expectations. |
Long-Run Phillips Curve (LRPC) | Vertical line at the natural rate of unemployment (NAIRU). No trade-off between inflation and unemployment in the long run. |
Natural Rate of Unemployment (NAIRU) | The level of unemployment at which inflation remains constant. |
Several factors can influence the position and slope of the Phillips Curve:
The expectations-augmented Phillips Curve has important policy implications: