Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Short-run and long-run Phillips curves
Compare short-run and long-run Phillips curves. Explain how changing inflation expectations remove a lasting inflation–unemployment trade-off.
The economic idea
The Phillips curve describes a relationship between inflation and unemployment. A short-run Phillips curve can slope downward for a given expected inflation rate because unexpectedly strong demand raises output and employment before wages and expectations fully adjust.
The natural rate of unemployment is the rate consistent with labour-market equilibrium once cyclical unemployment is absent; it mainly reflects frictional and structural unemployment. The NAIRU is the unemployment rate at which inflation has no tendency to accelerate or decelerate. The concepts are closely related but need not be numerically identical.
The long-run Phillips curve is vertical at the natural rate because expected inflation adjusts. Attempts to hold unemployment below that rate require repeatedly unexpected demand expansion and lead to accelerating inflation rather than a permanently lower unemployment rate.
Supply-side policies that improve matching, mobility, skills or labour-market efficiency may reduce the natural rate and shift LRPC left. Demand management alone cannot do so permanently in this model.
Reading a → b → c across SRPC₁, SRPC₂ and LRPC
“Unemployment rate” is on the horizontal axis and “Rate of inflation” is on the vertical axis. Both axes show rates, not the level of output or the price level.
“SRPC₁” and “SRPC₂” are short-run relationships at different expected inflation rates; “LRPC” is vertical at the natural rate.
“a” and “c” lie on “LRPC” at the natural rate, while “b” represents a short-run deviation.
Initial long-run position: a
“a” is where “SRPC₁” meets “LRPC”. Unemployment is at its natural rate and actual inflation equals expected inflation.
Short-run movement: a to b
Unexpected demand expansion moves the economy up and left along “SRPC₁” to “b”. Inflation rises and unemployment can temporarily fall below its natural rate.
Expectations adjustment: b to c
“SRPC₂” lies above “SRPC₁”, indicating higher expected inflation. “b” lies to the left of “LRPC”; unemployment is temporarily below the natural rate. The return to “c” on “LRPC” shows the long-run adjustment at the natural rate.
A lower natural rate requires a different mechanism
Better matching, relevant skills or greater labour mobility can reduce frictional or structural unemployment. In this model, that can shift the long-run Phillips curve left; it is different from using demand expansion to move temporarily along a short-run curve.
A vertical LRPC does not require inflation to be zero. It means that once expectations adjust, different sustained inflation rates are compatible with the same natural unemployment rate.
Why demand expansion cannot permanently beat the natural rate
The economy begins at “a” on “SRPC₁” and “LRPC”.
Unexpected demand expansion moves it to “b” along “SRPC₁”, temporarily lowering unemployment and raising inflation.
Workers and firms revise inflation expectations and nominal wage demands, shifting the short-run curve toward “SRPC₂”.
The economy reaches “c” on “LRPC”: unemployment returns to the natural rate, but inflation is higher.
Common mistakes to avoid
- “SRPC₁” shifting to “SRPC₂” is not movement along a curve; expected inflation has changed.
- “LRPC” does not mean zero unemployment. It stands at the natural rate, which includes frictional and structural unemployment.
- The natural rate and NAIRU are related analytical concepts, not automatically identical empirical estimates.
- Demand expansion can lower unemployment below the natural rate only temporarily in this model.
How to draw this diagram
- Title the diagram “Short-run and long-run Phillips curves”. Label the horizontal axis “Unemployment rate” and the vertical axis “Rate of inflation”.
- Draw SRPC₁ first and label it clearly.
- Draw SRPC₂ next and label it clearly.
- Draw LRPC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The curve is an analytical relationship, not a structural law that is stable across countries and time.
- Inflation expectations are difficult to observe and may be adaptive, rational or institutionally anchored.
- Supply shocks, productivity and labour-market reforms can shift the relationship independently of demand.
- Official unemployment can understate underemployment, discouraged workers and distributional differences.
- The natural rate and NAIRU are estimated with uncertainty and may change over time.