The Long-Run Phillips Curve is a fundamental concept in macroeconomics that depicts the relationship between inflation and unemployment over a longer timeframe. Unlike its short-run counterpart, which shows a trade-off between inflation and unemployment, the Long-Run Phillips Curve suggests that this trade-off disappears when expectations of inflation are fully adjusted.
Historical Context
The Phillips Curve originated from the work of A.W. Phillips in 1958, who empirically demonstrated an inverse relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom. This relationship was later generalized to inflation and unemployment. In the long run, however, economists like Milton Friedman and Edmund Phelps challenged this view, leading to the development of the Long-Run Phillips Curve.
Types/Categories
- Short-Run Phillips Curve: Shows an inverse relationship between inflation and unemployment for a given time period.
- Long-Run Phillips Curve: Represents the relationship when inflation expectations have fully adjusted, typically viewed as vertical at the NAIRU.
Key Events
- Phillips’ Original Work (1958): Demonstrated the short-run trade-off.
- Friedman-Phelps Critique (Late 1960s): Introduced the concept of NAIRU and the vertical Long-Run Phillips Curve.
- Stagflation (1970s): High inflation and unemployment co-existed, undermining the traditional Phillips Curve and supporting the vertical Long-Run Phillips Curve.
Detailed Explanation
The Long-Run Phillips Curve (LRPC) assumes that in the long run, expectations of inflation align with actual inflation, neutralizing any trade-off between inflation and unemployment. Therefore, the LRPC is typically depicted as a vertical line at the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
The NAIRU represents the unemployment rate at which inflation is stable. Deviations from the NAIRU can only temporarily affect inflation rates because, in the long run, adaptive expectations ensure that actual and expected inflation are equal.
Mathematical Models and Formulas
The Phillips Curve in the short run can be expressed as:
- \( \pi \) = Inflation rate
- \( \pi^e \) = Expected inflation rate
- \( \beta \) = Sensitivity of inflation to unemployment
- \( u \) = Actual unemployment rate
- \( u^* \) = Natural rate of unemployment or NAIRU
In the long run, when \( \pi = \pi^e \), the equation simplifies to:
Charts and Diagrams
graph TD
A(Vertical Long-Run Phillips Curve at NAIRU)
B(Short-Run Phillips Curve)
X[Unemployment Rate]
Y[Inflation Rate]
A -- At NAIRU --> X
B -- Short-Run Trade-Off --> Y
Importance and Applicability
Understanding the Long-Run Phillips Curve is crucial for:
- Monetary Policy: Central banks use it to formulate policies that stabilize inflation and unemployment.
- Economic Forecasting: Helps predict long-term economic trends.
- Policy Decisions: Guides fiscal policies aimed at controlling unemployment and inflation.
Examples
- High Inflation Periods: Central banks may tighten monetary policy to return the economy to the NAIRU.
- Recession Recovery: Temporary policies might reduce unemployment but only until inflation expectations adjust.
Considerations
- Inflation Expectations: They play a critical role in determining the shape and position of the Phillips Curve.
- Supply Shocks: Unexpected events (e.g., oil crises) can shift the Phillips Curve.
Related Terms with Definitions
- NAIRU: The unemployment rate at which inflation does not accelerate.
- Stagflation: A situation with high inflation and high unemployment.
- Adaptive Expectations: The theory that people’s expectations of future inflation are based on past inflation rates.
Comparisons
- Short-Run vs. Long-Run Phillips Curve: Short-run shows a trade-off; long-run does not.
- Classical Economics vs. Keynesian Economics: Different views on the flexibility of wages and prices, affecting the Phillips Curve interpretation.
Interesting Facts
- Adaptive vs. Rational Expectations: Rational expectations consider all available information, not just past inflation, influencing the Phillips Curve’s relevance.
Inspirational Stories
Milton Friedman and Edmund Phelps, by challenging the Keynesian perspective and emphasizing expectations, profoundly influenced modern economic thought and policy, underscoring the significance of empirical evidence and theoretical rigor in advancing knowledge.
Famous Quotes
“Inflation is always and everywhere a monetary phenomenon.” — Milton Friedman
Proverbs and Clichés
- “Expect the unexpected.”
- “History repeats itself, especially when it comes to economics.”
Expressions, Jargon, and Slang
- Disinflation: The process of slowing the rate of inflation.
- Hyperinflation: Extremely high and typically accelerating inflation.
FAQs
Q: What does the Long-Run Phillips Curve imply about unemployment and inflation? A: It suggests that in the long run, there’s no trade-off between inflation and unemployment as the curve is vertical at the NAIRU.
Q: How does monetary policy affect the Long-Run Phillips Curve? A: It aims to maintain inflation at target levels, indirectly influencing unemployment rates towards the NAIRU.
Q: Can the Long-Run Phillips Curve shift? A: Yes, factors like technological changes and labor market policies can shift the NAIRU.
References
- Friedman, Milton. “The Role of Monetary Policy.” American Economic Review, 1968.
- Phelps, Edmund S. “Phillips Curves, Expectations of Inflation, and Optimal Unemployment over Time.” Economica, 1967.
Summary
The Long-Run Phillips Curve is a pivotal concept in macroeconomics that redefines the relationship between inflation and unemployment over a longer timeframe. It underscores the importance of inflation expectations and posits that in the long run, unemployment gravitates towards the NAIRU, where inflation expectations match actual inflation. This has profound implications for monetary and fiscal policies, guiding economic decision-making to stabilize both inflation and employment levels.
