5.2 The Phillips Curve

The Phillips curve shows the relationship between inflation and unemployment. In the short run, the downward-sloping short-run Phillips curve (SRPC) shows a trade-off: lower unemployment usually comes with higher inflation.

Phillips Curve AP Macro Definition

The Phillips curve model represents the relationship between inflation and unemployment. The SRPC shows the short-run trade-off between inflation and unemployment, while the LRPC is vertical at the natural rate of unemployment. Demand shocks move the economy along the SRPC, supply shocks shift the SRPC, and changes in the natural rate of unemployment shift the LRPC.

The Phillips curve is a frequent challenge area on the AP Macroeconomics exam. Besides drawing the graph, you'll need to explain short-run versus long-run outcomes for inflation and unemployment.

What Moves and Shifts the Phillips Curve

• The SRPC slopes downward and shows the short-run trade-off between inflation and unemployment. The economy is always operating somewhere on it.
• The LRPC is vertical at the natural rate of unemployment, meaning there is no permanent trade-off in the long run.
• Long-run equilibrium is where the SRPC and LRPC intersect, at the natural rate of unemployment.
• Points left of long-run equilibrium (unemployment below natural rate) show an inflationary gap. Points right of it (unemployment above natural rate) show a recessionary gap.
• Demand shocks cause movement along the SRPC. Supply shocks shift the SRPC.
• Changes in the natural rate of unemployment shift the LRPC.

The Phillips Curve Model

The Phillips curve graphs the relationship between the inflation rate and the unemployment rate. It is closely tied to the AD-AS model, so the same events you analyze there show up here in a different form.

The horizontal axis measures the unemployment rate, and the vertical axis measures the inflation rate. There are two curves to know:

• The short-run Phillips curve (SRPC) slopes downward, showing the short-run trade-off between inflation and unemployment.
• The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment.

The economy is always operating at some point on the SRPC. Long-run equilibrium is where the SRPC crosses the vertical LRPC, which sits at the natural rate of unemployment (the same level of employment shown by the LRAS curve in the AD-AS model).

Inflationary and Recessionary Gaps

Where you are relative to long-run equilibrium tells you about output gaps:

• A point to the left of long-run equilibrium means unemployment is below the natural rate. This corresponds to an inflationary gap.
• A point to the right of long-run equilibrium means unemployment is above the natural rate. This corresponds to a recessionary gap.

Demand Shocks: Movement Along the SRPC

Demand shocks cause the economy to move along the existing SRPC. This is the short-run trade-off in action.

• When aggregate demand increases, inflation rises and unemployment falls. On the graph, you move up and to the left along the SRPC.
• When aggregate demand decreases, inflation falls and unemployment rises. On the graph, you move down and to the right along the SRPC.

This mirrors the AD-AS model. An increase in AD raises the price level and real GDP, which means higher inflation and lower unemployment. A decrease in AD lowers the price level and real GDP, which means lower inflation and higher unemployment. The point that moves from A to B in the AD-AS model corresponds to a movement from A to B along the SRPC.

In the long run, wages and expectations adjust, so unemployment returns to the natural rate and the economy settles back on the LRPC. That is why there is no permanent trade-off between inflation and unemployment.

Supply Shocks: Shifts of the SRPC

Supply shocks shift the entire SRPC instead of causing movement along it. A useful rule: when the SRAS curve shifts one direction, the SRPC shifts the opposite direction.

• A favorable supply shock shifts SRAS right, which shifts the SRPC left. Inflation and unemployment both fall.
• An adverse supply shock shifts SRAS left, which shifts the SRPC right. Inflation and unemployment both rise.

When inflation and unemployment rise at the same time, the economy is in stagflation. In this model, stagflation comes from an adverse supply shock that shifts the SRPC right. The oil price shocks of the 1970s are a common real-world example of an adverse supply shock, though that historical case is an application rather than required content.

In the long run, unemployment stays anchored at the natural rate shown by the LRPC unless the natural rate itself changes.

The Long-Run Phillips Curve

The LRPC is vertical at the natural rate of unemployment, which lines up with full employment and the LRAS curve. Because it is vertical, it shows there is no long-run trade-off between inflation and unemployment. Policies that try to push unemployment below the natural rate end up only changing the inflation rate in the long run, not the unemployment rate.

Factors that change the natural rate of unemployment shift the LRPC:

• If the natural rate rises, the LRPC shifts right.
• If the natural rate falls, the LRPC shifts left.

Things that can change the natural rate include shifts in labor market institutions, how efficiently workers and jobs match, demographics, and government labor-market policies.

Telling Movement Along the SRPC From a Shift

Free Response: When a free-response question describes an event, decide first whether it is a demand shock or a supply shock. That choice tells you whether to show movement along the SRPC or a shift of the SRPC. Then walk through the full chain: name the cause, show the graph change, and state what happens to both inflation and unemployment.

Label everything: both axes, the SRPC, the vertical LRPC, the natural rate of unemployment, and your starting and ending points. Unlabeled graphs lose easy points.

MCQ: Multiple-choice questions often test whether you can tell movement from a shift. If the prompt is about a change in aggregate demand, expect movement along the SRPC. If it is about a supply shock, expect a shift of the SRPC. Questions may also ask you to connect a point on the Phillips curve to an inflationary or recessionary gap.

Common Trap: Remember the inverse direction rule for supply shocks. A rightward shift of SRAS goes with a leftward shift of the SRPC, and a leftward shift of SRAS goes with a rightward shift of the SRPC. Mixing this up is one of the most common errors on this topic.

Common Misconceptions

• Misconception: The short-run trade-off is permanent.
  Actually: The short-run trade-off is not permanent. In the long run, unemployment returns to the natural rate, so the LRPC is vertical and there is no lasting trade-off.
• Misconception: Demand shocks shift the SRPC.
  Actually: Demand shocks do not shift the SRPC. They cause movement along it. Only supply shocks shift the SRPC.
• Misconception: A point on the LRPC means zero unemployment.
  Actually: A point on the LRPC does not mean zero unemployment. It means unemployment is at the natural rate, which still includes frictional and structural unemployment.
• Misconception: Stagflation is caused by a demand shock.
  Actually: Stagflation is not caused by a demand shock. It comes from an adverse supply shock that raises both inflation and unemployment.
• Misconception: Left of long-run equilibrium is a recessionary gap.
  Actually: Left of long-run equilibrium is not a recessionary gap. Unemployment below the natural rate is an inflationary gap. Unemployment above the natural rate (to the right) is a recessionary gap.
• Misconception: The SRAS and SRPC shift the same direction.
  Actually: The SRAS and SRPC do not shift the same direction. They move in opposite directions.

Related AP Macroeconomics Guides

• 5.1 Fiscal and Monetary Policy Actions in the Short-Run
• 5.5 Crowding Out
• 5.3 Money Growth and Inflation
• 5.4 Deficits and the National Debt
• 5.6 Economic Growth
• Unit 5 Review: Long-Run Consequences of Stabilization Policies