AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/5/5-2)
Unit 5 · Topic 5.2
5.2 The Phillips Curve
The Phillips curve model shows how inflation and unemployment are related. In the short run there's a tradeoff: changes that lower unemployment tend to raise inflation. In the long run there's no tradeoff, because unemployment returns to its natural rate whatever the inflation rate is.
Key terms
- short-run Phillips curve (SRPC)
- long-run Phillips curve (LRPC)
- natural rate of unemployment
- supply shock
- inflationary expectations
- stagflation
Drawing the model
Label the graph as listed below. Mark the natural rate of unemployment on the horizontal axis (often written UN) and the long-run equilibrium inflation rate on the vertical axis (inf1).
- Vertical axis: inflation rate (%).
- Horizontal axis: unemployment rate (%).
- Short-run Phillips curve (SRPC): slopes downward. In the short run, higher inflation goes with lower unemployment.
- Long-run Phillips curve (LRPC): a vertical line at the natural rate of unemployment, the rate at full employment, made up of frictional and structural unemployment.
- Long-run equilibrium: the point where the SRPC crosses the LRPC.
How it connects to AD–AS
The economy is always somewhere on its current SRPC. A point on the SRPC to the left of the LRPC has unemployment below the natural rate, which means an inflationary (positive) output gap. A point to the right has unemployment above the natural rate, which means a recessionary (negative) gap.
Each change in the AD–AS model has a matching change in the Phillips curve model. A rule of thumb: demand changes move the economy along the SRPC; supply changes shift the SRPC.
| AD–AS change | Phillips curve result |
|---|---|
| AD increases (a demand shock) | Move up and to the left along the SRPC: inflation rises, unemployment falls |
| AD decreases | Move down and to the right along the SRPC: inflation falls, unemployment rises |
| SRAS decreases (a negative supply shock, such as an oil price spike) | SRPC shifts right: inflation and unemployment both rise, which is called stagflation |
| SRAS increases (a positive supply shock) | SRPC shifts left |
| The natural rate of unemployment changes | LRPC shifts; a lower natural rate shifts it left |
Expectations and the long run
Each SRPC is drawn for a given expected inflation rate. If people come to expect higher inflation, workers ask for bigger raises and firms raise prices faster. SRAS shifts left, and the SRPC shifts right (up). Lower expected inflation shifts the SRPC left.
Suppose AD rises and moves the economy up along the SRPC: unemployment falls below the natural rate and inflation rises. As people raise their inflation expectations, the SRPC shifts right. In the long run, unemployment returns to the natural rate, but at a higher expected inflation rate.
That's why the LRPC is vertical. In the long run, policy that changes AD can change the inflation rate, but not the natural rate of unemployment.
What shifts the LRPC
The LRPC moves only when the natural rate of unemployment changes. That happens when frictional unemployment (people between jobs) or structural unemployment (a mismatch between workers' skills or locations and the jobs available) changes. Better job-search tools or retraining programs can lower the natural rate and shift the LRPC left. A change in inflation alone never shifts the LRPC.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Placing an economy on the graph
In Country T, the labor force is 20 million people and 1.4 million are unemployed. The natural rate of unemployment is 5%, and the inflation rate is 2%. (a) Calculate the unemployment rate. (b) Describe a correctly labeled Phillips curve graph showing where the economy is, and name the kind of gap.
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- Step 1: (a) Unemployment rate = unemployed ÷ labor force × 100 = 1.4 million ÷ 20 million × 100 = 7%.
- Step 2: (b) Put the inflation rate (%) on the vertical axis and the unemployment rate (%) on the horizontal axis. Draw the LRPC as a vertical line at 5%.
- Step 3: Draw a downward-sloping SRPC and mark the economy's point on it at 7% unemployment and 2% inflation. That point is to the right of the LRPC.
- Step 4: Unemployment is above the natural rate, so the economy has a recessionary (negative) output gap.
Answer: (a) 7%. (b) The point (7% unemployment, 2% inflation) lies on the SRPC to the right of the LRPC at 5%: a recessionary gap.
- Example 2
An oil price shock
A sharp rise in the price of oil, an input used by many firms, hits the economy. Show the effect on the Phillips curve model, and name the situation.
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- Step 1: In AD–AS terms, higher input costs shift SRAS left: the price level rises and real GDP falls, so unemployment rises.
- Step 2: In the Phillips curve model, that's a supply shock, so the SRPC shifts right from SRPC1 to SRPC2.
- Step 3: The economy moves to a point on SRPC2 with both higher inflation and higher unemployment than before. The LRPC doesn't move, because the natural rate hasn't changed.
- Step 4: Rising inflation together with rising unemployment is called stagflation.
Answer: The SRPC shifts right; inflation and unemployment both rise (stagflation); the LRPC stays put.
- Example 3
Movement or shift? (classic trap)
The central bank lowers interest rates, and AD increases. A student shows this by shifting the SRPC to the left. What should the graph show?
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- Step 1: An increase in AD is a demand shock, not a supply shock.
- Step 2: Demand shocks move the economy along the existing SRPC. Higher AD means higher inflation and lower unemployment: a move up and to the left on SRPC1.
- Step 3: The SRPC shifts only if supply conditions or expected inflation change. In the long run, if people come to expect the higher inflation, the SRPC shifts right, not left.
Answer: A movement up and to the left along the original SRPC, with no shift in the short run.
Common mistakes
- Shifting the SRPC when AD changes. Demand changes move the economy along the SRPC; supply shocks and changes in expected inflation shift it.
- Swapping the axes. The inflation rate goes on the vertical axis and the unemployment rate on the horizontal axis.
- Shifting the LRPC when inflation changes. The LRPC is vertical at the natural rate of unemployment and moves only when that rate changes.
- Getting the direction of a supply shock wrong. A negative supply shock shifts the SRPC right (up), not left.
On the exam
- Free-response questions often give the unemployment rate, the inflation rate and the natural rate, then ask you to draw the SRPC and LRPC and mark the economy's point. Put the LRPC at the natural rate and the point on the correct side of it.
- You may be asked what happens to the SRPC in the long run after a gap. Tie your answer to changing inflation expectations, and say the economy returns to the natural rate of unemployment.
Connected topics
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Check yourself
5 questions on 5.2 The Phillips Curve. Pick an answer to see if you got it, and why.
A Phillips curve graph for Country P has the inflation rate (%) on the vertical axis and the unemployment rate (%) on the horizontal axis.
The long-run Phillips curve (LRPC) is vertical at an unemployment rate of 5 percent. The short-run Phillips curve (SRPC1) slopes downward and crosses the LRPC at an inflation rate of 2 percent; call this point A.
The economy is currently at point B on SRPC1, where unemployment is 3 percent and inflation is 4 percent.
Hypothetical scenario
Point B indicates that Country P currently has
Which of the following would most likely have moved Country P from point A to point B?
If no policy action is taken, what will happen to Country P in the long run?
Which of the following would shift Country P's LRPC to the left?
On a correctly drawn AD–AS graph for Country P, which of the following matches point B?
0 of 5 answered