The Relationship Between Inflation and Unemployement with the Long-run Phillips Curve

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The Long- Run Phillips Curve (LRPC)

The Long- Run Philips Curve, LRPC shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. If unemployment falls below its natural rate, inflation will accelerate and vise- versa.
The LRPC is a vertical line at the Natural Unemployment Rate (Frictional Unemployment plus Structural Unemployment).
Along the LRPC, an increase in the inflation rate will have no effect on the unemployment rate.

The Short-Run Phillips Curve (SRPC)

SRPC indicates the negative relationship of trade-off between inflation and unemployment.
The LRPC curve is a vertical line at the natural rate of unemployment, but the SRPC curve is roughly L-shaped.
Only in the short-run, the inverse relationship shown by the SRPC exists; there is no trade-off between inflation and unemployment in the long run.
To show the relationship between inflation and unemployment we will have to refer to The Philip Curve by A.W.Phillips as shown in Figure 1.

Figure 4: The Philip Curve
Source from: http://www.bized.co.uk

Figure 4 shows the curve sloped downward from left to right and that inflation and unemployment are inversely related. The negative relationship between inflation rate and unemployment rate can be explained by the aggregate demand, AD and aggregate supply, AS model. An unexpectedly large increase in AD raises the inflation rate and increase real GDP, which lowers the unemployment rate. Hence, higher inflation is associated with lower unemployment shown by a movement along a short run PC. Thus, when there is high inflation, there is low unemployment and when there is low inflation, there is high unemployment. For example, based on Table 1 and Table 2 in ...

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... no change in the unemployment in the long- run.

1970's Phenomenon- Stagflation

As we have mentioned earlier that inflation and unemployment are inversely related. When inflation decrease, unemployment increase and when inflation increase, unemployment decrease. However during the year 1970's, both inflation and unemployment increased at the same time which is totally against the classic Phillips Curve Theory. This phenomenon is known as stagflation. Based on NAIRU theory this phenomenon can be explained. According to the theory of NAIRU, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the SRPC and increasing the prevailing rate of inflation in the economy. At same time, unemployment rates were not affected, leading to high inflation and high unemployment in the 1970's.

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