The Phillips Curve

1. The Phillips curve maps the rate of inflation against the rate of unemployment, capturing the central conflict between two key macro objectives.
2. A demand-driven boom that cuts unemployment tends to raise inflation, so the short-run curve slopes downward.
3. Once workers adjust their inflation expectations the economy returns to the natural rate, so the long-run curve is vertical and offers no lasting trade-off.

The Traditional Short-Run Curve

1. The rate of unemployment is measured on the horizontal axis and the rate of inflation on the vertical axis.
2. The curve slopes downward because heavier demand for labour bids up wages and prices as spare capacity shrinks.
3. A rise or fall in aggregate demand is shown as a movement along the curve, not a shift of it.
4. Cause to effect: stronger demand raises output, firms hire more, unemployment falls, and the tighter labour market pushes pay and prices up.

Linking to AD-AS and Output Gaps

1. A rise in aggregate demand lowers unemployment as firms hire more workers to meet extra orders.
2. The same rise adds to inflation as the economy nears full capacity and shortages appear.
3. A positive output gap therefore lines up with low unemployment and higher inflation.
4. A negative output gap lines up with high unemployment and low inflation.

The Expectations-Augmented Curve

1. Holding unemployment below the natural rate first raises inflation as demand outstrips supply.
2. Workers then expect higher inflation and demand higher money wages to protect their real pay.
3. Higher wage costs make firms cut hiring, so unemployment drifts back to the natural rate.
4. The economy ends at the natural rate but with higher inflation, so the short-run curve has shifted up.

The Long-Run Curve and the NAIRU

1. Cause to effect: expectations adjust, so any attempt to hold unemployment below the natural rate only accelerates inflation.
2. At the natural rate the labour market clears, so a stable inflation rate can be sustained at any level.
3. This natural rate is a supply-side equilibrium, not zero unemployment, since search and skills mismatch remain.

Shifting the Long-Run Curve

1. The natural rate depends on how well the labour market matches workers to jobs.
2. Better skills and training cut structural unemployment by making workers employable in growing industries.
3. Improved job-search information and stronger work incentives cut frictional unemployment.
4. These supply-side gains lower the natural rate and shift the long-run curve to the left.

Evaluation: Stagflation and Limits

1. In the 1970s many economies suffered stagflation, with high inflation and high unemployment at the same time.
2. Oil price shocks caused cost-push inflation while output fell, so both variables rose together and broke the simple stable trade-off.
3. This experience pushed economists towards the expectations-augmented model and reshaped how central banks anchor inflation.
4. The short-run curve stays a useful near-term guide, but expectations and the vertical long-run curve deny any lasting trade-off.
5. It depends: supply-side reform can lower the natural rate, but it works slowly and the size of the effect is uncertain.
6. How binding the short-run trade-off is also depends on credibility: when a central bank's inflation target is believed, expectations stay anchored and the short-run curve is flat, so a fall in unemployment brings only a small rise in inflation; when credibility is weak, expectations adjust fast and even a small fall in unemployment triggers sharply higher inflation, so the trade-off is barely usable.