The Phillips Curve Graph illustrates the inverse relationship between inflation and unemployment, suggesting that lower unemployment rates correlate with higher inflation rates. This concept is significant in understanding trade-offs that policymakers face when addressing economic conditions, as the graph can shift due to supply shocks or changes in inflation expectations.
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The original Phillips Curve was developed by A.W. Phillips in 1958 based on empirical data from the UK, showing a clear trade-off between inflation and unemployment.
In the long run, the Phillips Curve is vertical, indicating that there is no trade-off between inflation and unemployment once expectations adjust, leading to natural rates of unemployment.
Supply shocks, such as oil price increases, can shift the Phillips Curve outward, leading to higher inflation and higher unemployment simultaneously, known as stagflation.
The expectations-augmented Phillips Curve incorporates adaptive expectations, recognizing that people adjust their expectations about inflation based on past experiences.
Policymakers must consider the implications of the Phillips Curve when implementing monetary policy, as trying to reduce unemployment below its natural rate can lead to accelerating inflation.
Review Questions
How does the Phillips Curve illustrate the relationship between inflation and unemployment, and what are its implications for economic policy?
The Phillips Curve shows that there is an inverse relationship between inflation and unemployment, suggesting that lower unemployment tends to come with higher inflation. This implies that policymakers face trade-offs when trying to achieve economic goals; for example, reducing unemployment may lead to rising inflation. Understanding this relationship helps guide monetary policy decisions aimed at stabilizing the economy.
Discuss how supply shocks can affect the Phillips Curve and what this means for inflation and unemployment.
Supply shocks, like sudden increases in oil prices, can shift the Phillips Curve outward. This results in both higher inflation and higher unemployment, a phenomenon known as stagflation. It challenges traditional views that suggest a straightforward trade-off between inflation and unemployment, illustrating how external factors can complicate economic dynamics and policymaking.
Evaluate the relevance of the expectations-augmented Phillips Curve in today's economic landscape, particularly regarding inflation targeting by central banks.
The expectations-augmented Phillips Curve remains relevant today as it emphasizes the role of adaptive expectations in shaping inflation dynamics. Central banks often target inflation rates to stabilize prices and manage economic growth. By acknowledging that people adjust their expectations based on past inflation, central banks can better navigate the complexities of maintaining low unemployment while keeping inflation within desired bounds, ultimately fostering a more stable economy.
Related terms
Inflation: The rate at which the general level of prices for goods and services rises, eroding purchasing power.
Unemployment Rate: The percentage of the labor force that is jobless and actively seeking employment.
Aggregate Demand: The total demand for goods and services within a particular market or economy at a given overall price level and in a given time period.