The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run.
However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.
Short-Run Phillips Curve : The short-run Phillips curve shows that in the short-term there is a tradeoff between inflation and unemployment. Contrast it with the long-run Phillips curve in red , which shows that over the long term, unemployment rate stays more or less steady regardless of inflation rate. Consider the example shown in. Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and unemployment in the short-run.
Given a stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output increases, unemployment decreases. With more people employed in the workforce, spending within the economy increases, and demand-pull inflation occurs, raising price levels. Therefore, the short-run Phillips curve illustrates a real, inverse correlation between inflation and unemployment, but this relationship can only exist in the short run.
The idea of a stable trade-off between inflation and unemployment in the long run has been disproved by economic history. There are two theories of expectations adaptive or rational that predict how people will react to inflation. Yet, how are those expectations formed?
There are two theories that explain how individuals predict future events. To fully appreciate theories of expectations, it is helpful to review the difference between real and nominal concepts.
Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for inflation. To make the distinction clearer, consider this example. This is the nominal, or stated, interest rate. The difference between real and nominal extends beyond interest rates.
The distinction also applies to wages, income, and exchange rates, among other values. The theory of adaptive expectations states that individuals will form future expectations based on past events. For example, if inflation was lower than expected in the past, individuals will change their expectations and anticipate future inflation to be lower than expected.
To connect this to the Phillips curve, consider. This way, their nominal wages will keep up with inflation, and their real wages will stay the same. Expectations and the Phillips Curve : According to adaptive expectations theory, policies designed to lower unemployment will move the economy from point A through point B, a transition period when unemployment is temporarily lowered at the cost of higher inflation.
However, eventually, the economy will move back to the natural rate of unemployment at point C, which produces a net effect of only increasing the inflation rate. According to rational expectations theory, policies designed to lower unemployment will move the economy directly from point A to point C.
The transition at point B does not exist as workers are able to anticipate increased inflation and adjust their wage demands accordingly. Now assume that the government wants to lower the unemployment rate.
To do so, it engages in expansionary economic activities and increases aggregate demand. As aggregate demand increases, inflation increases.
Because of the higher inflation, the real wages workers receive have decreased. Consequently, employers hire more workers to produce more output, lowering the unemployment rate and increasing real GDP. On, the economy moves from point A to point B. However, workers eventually realize that inflation has grown faster than expected, their nominal wages have not kept pace, and their real wages have been diminished.
As labor costs increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the economy moves from point B to point C. This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself to the natural rate of unemployment with higher inflation.
The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will be very close to the market equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will take this past information and current information, such as the current inflation rate and current economic policies, to predict future inflation rates. As an example of how this applies to the Phillips curve, consider again.
However, under rational expectations theory, workers are intelligent and fully aware of past and present economic variables and change their expectations accordingly. They will be able to anticipate increases in aggregate demand and the accompanying increases in inflation.
As such, they will raise their nominal wage demands to match the forecasted inflation, and they will not have an adjustment period when their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point A to point C, without transitioning to point B. In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically undermined by rational workers.
They can act rationally to protect their interests, which cancels out the intended economic policy effects. Dictionary of Economic Terms A-F.
Dictionary of Economic Terms G-Z. Economy Economics. Table of Contents Expand. Historical Trends. Recent Trends. The Bottom Line. Key Takeaways According to economic theory, as unemployment rates fall, the rate of inflation rises. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.
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Investopedia does not include all offers available in the marketplace. Related Articles. Macroeconomics Stagflation in the s. Macroeconomics An Explanation of Stagflation. Economics 9 Common Effects of Inflation. This is known as "Okun's law. The larger increase in output is due to more people discouraged workers reentering the labor force. In January of the inflation rate was 2. But what does this mean? An inflation rate of 2. In the chapter on aggregate supply and aggregate demand we learned that the price level is "the average level of prices in the economy".
We find the price level on the vertical axis of the AS-AD graph. But how is the price level measured? What numbers would one put along the vertical axis? How can we measure the average level of prices in an economy? To do this economists use a "price index". In order to calculate inflation we need to know how the price level is measured, therefore we need to learn about a price index.
A list of over items bought by the typical consumer is drawn up. The list is then "weighted" meaning that they do not include 1 car, 1, computer, 1 house, 1 pizza, one gallon of gasoline, etc. Instead they "weight" each item according to its share in the typical consumer's budget.
Each month data collectors collect prices of each item in the "market basket" and an average price is calculated. The price of the market basket each month is compare to its price in a "base year". So, in the CPI was Or the price was Each month, BLS data collectors called economic assistants visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI.
These economic assistants record the prices of about 80, items each month representing a scientifically selected sample of the prices paid by consumers for the goods and services purchased. During each call or visit, the economic assistant collects price data on a specific good or service that was precisely defined during an earlier visit. If the selected item is available, the economic assistant records its price.
If the selected item is no longer available, or if there have been changes in the quality or quantity for example, eggs sold in packages of 8 when they previously had been sold by the dozen of the good or service since the last time prices had been collected, the economic assistant selects a new item or records the quality change in the current item.
The recorded information is sent to the national office of BLS where commodity specialists who have detailed knowledge about the particular goods or services priced review the data. These specialists check the data for accuracy and consistency and make any necessary corrections or adjustments which can range from an adjustment for a change in the size or quantity of a packaged item to more complex adjustments based upon statistical analysis of the value of an item's features or quality.
Thus, the commodity specialists strive to prevent changes in the quality of items from affecting the CPI's measurement of price change. To track prices, the Labor Department sends out hundreds of people around the country to monitor prices for everything Americans buy -- from tires to food and college tuition.
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Table of Contents Expand. Labor Supply and Demand. The Phillips Curve. Phillips Curve Implications. Monetarist Rebuttal. Relationship Breakdown. CPI vs. Current Environment Wages. The Bottom Line. Article Sources. Investopedia requires writers to use primary sources to support their work.
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