Demand shocks move output and the price level the same way. Translate that into the two numbers people watch most, the The Unemployment Rate and the Inflation, Deflation and Disinflation, and you get the Phillips curve.
Key idea
The short-run Phillips curve (SRPC) shows an inverse relationship between unemployment and inflation. A shift of AD moves the economy along the SRPC. A supply shock or a change in expected inflation shifts the SRPC. At the natural rate of unemployment, inflation equals expected inflation.
Why it works
When AD shifts right, firms produce more, so they hire and unemployment falls; at the same time the price level rises faster, so inflation rises. That is a move up and to the left along the SRPC. A negative supply shock raises prices while output falls, so inflation and unemployment rise: the whole curve shifts up and to the right. If people expect more inflation, they build it into wages and prices, so inflation is higher at every unemployment rate: also a shift up.
Worked examples
Worked example: Move or shift?
What happens on the SRPC? (a) Government purchases rise. (b) Oil prices jump.
- (a) AD shifts right: unemployment falls, inflation rises: a movement up and to the left along the SRPC.
- (b) SRAS shifts left: both inflation and unemployment rise: the SRPC shifts up and to the right.
Answer: (a) along the curve; (b) the curve shifts
Worked example: Using a Phillips curve equation
The SRPC is $\pi = 3 - 0.5(u - 5)$ (percent). What is inflation at 3% unemployment?
- $\pi = 3 - 0.5(3 - 5) = 3 - 0.5(-2) = 3 + 1 = 4\%$.
- Unemployment below the natural rate (5%) comes with inflation above the expected 3%.
Answer: 4%
The curve is named for A. W. Phillips, who in 1958 found that British wages rose faster in years of low unemployment. In the 1970s, supply shocks and rising expectations brought high inflation and high unemployment together, a reminder that the short-run curve can shift.
Common mistake
Shifting the short-run Phillips curve when AD changes. AD shifts move the economy along it, while supply shocks and changes in expected inflation shift it. Check: did both inflation and unemployment move the same way? Then the curve shifted.
See it with real data: the U.S. unemployment rate and CPI inflation on the Economic Data page. Look for years when they move in opposite directions, and for years when they rise together.