What is Philips curve? How does it relate to Inflation and Unemployment:

 

What is Philips curve? How does it relate

to Inflation and Unemployment:

The term Philips curve is a concept in macro-economic that shows an 

inverse relationship between inflation and unemployment rates. 

The Relationship to Philips curve, this curve shows a tradeoff between 

inflation and unemployment as inflation tend to increase, unemployment 

tends to decrease and vice versa. It described as a negative relationship.

The short-run Philips curve states that higher inflation rates are associated 

with lower level of unemployment and vice versa. It shows that policy 

makers can  choose various combination of inflation and unemployment, 

but only in short run. The long-run Philips curve states that there is no 

permanent tradeoff between inflation and employment. In the long run, the 

economy tends to return to a natural rate of unemployment, and changes in 

inflation do not affect this rate. The notion is recognized as the 

"natural rate of unemployment."

Aggregate Supply and the short-run Tradeoff between Inflation 

and Unemployment (how shifts in Aggregate Demand leads to 

Short run fluctuation):

Interpretation:

Here figure shows the economy begins in a long-run equilibrium., point A. 

In the short run the equilibrium shifts from point A to point B. 

Higher output means lower unemployment because firm enjoy more 

workers when they produce more. A Higher price level means higher 

inflation. When aggregate demand increases unexpectedly, the price level 

rises from  P₁ to P₂ (because people did not expect this increase in price level, 

the expected price level remains at  E P₂, and output rises from  Y₁ to Y₂, 

causing the short-runaggregate supply curve to shift upward. Thus, when 

policymakersmove the economy up along the short-run aggregate supply 

curve, the reducethe unemployment rate and raise the inflation rate. Point C,

where output is once again at its natural level, represents the economy's 

return to a new long-run equilibrium.

Shifts in the short-run trade off:

Expected inflation affects the short-term trade-off between inflation and 

unemployment. When inflation expectations are higher, the curve is higher.