The The Short-Run Phillips Curve suggests a menu: a little more inflation for a little less unemployment. But self-adjustment warns that wages and expectations catch up. What happens to the menu in the long run?
Key idea
The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment. In the long run, unemployment returns to the natural rate whatever the inflation rate. Only a change in the natural rate (frictional or structural unemployment) shifts the LRPC.
Why it works
Suppose policy pushes unemployment below the natural rate. Inflation rises above what people expected. Workers and firms notice and come to expect the higher inflation, building it into wages and prices: the SRPC shifts up. To keep unemployment low, policy must push inflation higher still, and expectations follow again. Once policy stops pushing, unemployment returns to the natural rate, but inflation stays at the new, higher expected rate. The tradeoff exists only while inflation surprises people. Milton Friedman and Edmund Phelps made this argument in the late 1960s, before the 1970s bore it out.
Worked examples
Worked example: Chasing low unemployment
The SRPC is $\pi = \pi^e - 1(u - 5)$. Expected inflation is 2%, and policy holds unemployment at 4% this year and next. People expect each year's inflation to equal last year's. Find inflation in both years.
- This year: $\pi = 2 - (4 - 5) = 3\%$.
- Next year people expect 3%: $\pi = 3 - (4 - 5) = 4\%$.
- Holding unemployment below the natural rate takes inflation that keeps rising.
Answer: 3%, then 4%
Worked example: What moves the LRPC?
Job-search websites help workers and employers find each other faster. What happens to the LRPC?
- Faster matching lowers frictional unemployment, so the natural rate falls.
- The LRPC shifts left. (A change in expected inflation would shift the SRPC instead.)
Answer: It shifts left
Common mistake
Treating the short-run tradeoff as permanent, believing a government can hold unemployment low forever by accepting higher inflation. Once expectations adjust, unemployment returns to its natural rate. Check: in the long run, which variable can policy choose? Inflation, not unemployment.