Long run and short run Phillips curves

Let's talk a little bit about the short run and long run Phillips curve. Now, they're named after the economist Bill Phillips, who saw in the 1950s what looked like an inverse relationship between inflation and the unemployment rate. He was studying decades of data sets in the United Kingdom, where he saw usually when we had high, or when the United Kingdom had high inflation, you had relatively low unemployment, and that tended to be when the economy was doing well. So, he would see these data points from different years, and then he would see that when there was a high unemployment rate, when the economy was a little bit slower, then you had low inflation.

So, he theorized the existence of a curve that could describe this relationship. Maybe it looks something like this. If we take this model, or if we assume this model, then it would hold that when the economy is strong, you have high inflation and low unemployment. When the economy is weak, you have high unemployment and low inflation.

Now, you fast forward to the 1970s, and economists started to see a situation where this broke down. In the 1970s in particular, you saw situations of stagflation where you had both high unemployment and high inflation. So, it didn't seem to fit the Phillips curve. Economists theorized that maybe this thing that Phillips theorized is really just what happens in the short run. So, they said that this is the short run Phillips curve. But they theorized that there's actually a long run Phillips curve as well that describes the natural rate of unemployment, or the natural rate of unemployment you would get when the economy is at full employment.

And remember, full employment doesn't mean everyone's employed; it just means the sustainable rate of employment for the country. If we wanted to draw that long run Phillips curve that economists theorized in the 1970s, it might look something like this. When you see it as a vertical line like this, let me write this long run Phillips curve. It shows that over the long run, the unemployment rate would be this value right over here, irrespective of what's going on with inflation.

Let's say for this economy, our natural rate of unemployment is 4, and we see that it is associated with one percent inflation. You could imagine if there are some perturbations to the economy; maybe the economy gets a little bit overheated. Well, then you could get a little bit higher inflation and lower unemployment, or if the economy slows down a little bit, you could have higher unemployment and lower inflation. But it should gravitate back to the long run Phillips curve.

Now, let's think about this in the context of our aggregate demand and aggregate supply model, and think about a scenario where our short run Phillips curve could actually shift. Here we have our typical axes when we're thinking about aggregate demand and aggregate supply. We have real GDP on our horizontal axis and the price level on our vertical axis. Our aggregate demand curve might look something like this; it is downward sloping, so let's call that our aggregate demand curve.

Our short run aggregate supply curve might look something like this. As price levels go up in the short run, people are going willing to produce more. So, this is our short run aggregate supply. Remember, when we talked about aggregate demand and aggregate supply, we talked about a notion of our full employment output, which you could view as the sustainable rate of output for an economy. We can draw that as a vertical line.

This right over here would be our long run aggregate supply, and where it intersects our real GDP axis, this is our full employment output. If you want to put some numbers on it, maybe this is equal to, for a small economy, maybe this is equal to 50 billion dollars. The way we've just described this, we are at equilibrium right now. We're at full employment output; our economy is producing 50 billion dollars per year, and our full employment output implies an unemployment rate of four percent, where we have one percent inflation.

Now, let's say that there's some type of a demand shock. Let's say all of a sudden the government wants to stimulate the economy even beyond where it is here. So, you have a shift in the aggregate demand curve, so it would shift to the right. The aggregate demand curve would now look something like this; let's call that aggregate demand 2. What happens now?

We've seen this in previous videos. Now, you have—we go from this equilibrium point, which was at this full employment output and at this price level; let's call that price level one—and now we're at this equilibrium point. People are demanding more, so suppliers say, "Hey, if you want me to produce more, I'm going to charge you some more for it too." Our price level has gone up. We are at price level 2, and we are producing above full employment output. Maybe this level right here is 60 billion.

Well, how would that be reflected on our Phillips curves? Well, in the short run, our economy has gotten a little bit above potential. So, in the short run, we would sit on the short run Phillips curve, and our unemployment rate would go down. But if we assume the Phillips curve—the short run Phillips curve model—that means our inflation would go up. So, this point right over here might correspond maybe to this point right over there, where when we get to that beyond full employment output—let's say that this is 60 billion right over here—well, maybe our unemployment rate is 2, and our inflation rate here is three percent.

Now, what happens next? Well, we've talked about this when we studied aggregate demand and aggregate supply. Workers, when it's time for them to renegotiate their contracts, will say, "Hey, prices have gone up. I'm not going to work for the same amounts over the long run." So, you have a shift to the left of the aggregate supply curve. At any given price level, there's going to be less supply, less output.

If this shifts to the left, eventually the equilibrium point will go back to where everything intersects with the long run aggregate supply curve. So, the short run aggregate supply curve shifts over there, and then we would be back to our full employment output. Although our price level would have gone even higher—price level three.

Now, many economists would argue that when you have a shift in the short run aggregate supply—so this would be short run aggregate supply 2—that that also is associated with a shift in our short run Phillips curve because of these price increases. Because workers have been trying to renegotiate their salaries upwards, and labor is the biggest factor in price levels, you might have increased inflation expectations.

So, at a given rate of inflation, you might start having higher unemployment. This short run Phillips curve could shift to the right. Instead of just gravitating back to where it was before, the whole curve could shift to the right. We get to a situation that looks like this, where our inflation is still at three percent, but we are back to the long run unemployment rate of this economy.