Long run and short run Phillips curves

– [Tutor] Let’s talk a little bit about the short run and long run Phillips curve, now they’re named after the
economist, Bill Phillips, who saw in the 1950s what looked like an inverse relationship between inflation and
the unemployment rate and he was studying decades of datasets in the United Kingdom, where he saw usually when we had high, or when the United Kingdom
had high inflation, you had relatively low unemployment and that tended to be when
the economy was doing well, so he would see these data points from the different years
and then he would see that when there was a
high unemployment rate, when the economy was a little bit slower, then you had low inflation and so he theorized the
existence of a curve, that could describe this relationship, maybe it looks something like this and if we take this model
or if we assume this model, then it would hold that
when the economy is strong, you have high inflation, low unemployment, when the economy is weak, you have high unemployment
and low inflation. Now you fast forward to the 1970s and economists started to see a situation, where this broke down, in
the 1970s in particular, you saw situations of stagflation, where you had both high
unemployment and high inflation, so it didn’t seem to
fit the Phillips curve and so economists theorized that, okay, maybe this thing
that Phillips theorized is really just what
happens in the short run, so they said that this is
the short run Phillips curve, but they theorized that there’s actually a long run Phillips curve as well, that describes the natural
rate of unemployment or the natural rate of
unemployment you would get, when the economy is at full employment and remember, full employment doesn’t mean everyone’s employed, it just means a sustainable rate of
employment for the country and so if we wanted to draw
that long run Phillips curve, that economists theorized in the 1970s, it might look something like this and when you see it as a
vertical line like this, let me write this, long
run Phillips curve, it shows that over the long run, the unemployment rate would
be this value right over here irrespective of what’s
going on with inflation and so let’s say for this economy, our natural rate of unemployment is 4% and we see that it is
associated with 1% inflation and so you can imagine, if there’s some
perturbations to the economy, maybe the economy gets
a little bit overheated, well then, you could get a little bit higher inflation and lower unemployment or if the economy slows down a little bit, you could have higher
unemployment and lower inflation, but it should gravitate back
to the long run Phillips curve. But now let’s think about this in context of our aggregate demand,
aggregate supply model and think about a scenario, where our short run Phillips
curve could actually shift. So here we have our typical axes, when we’re thinking about aggregate demand and aggregate supply, we have real GDP on our horizontal axis, the price level on our vertical axis and so our aggregate demand curve might look something like
this, it is downward sloping, so let’s call that our
aggregate demand curve and then our short run
aggregate supply curve might look something like this, so as price levels go up in the short run, people are willing to produce more, so this is our short run aggregate supply and remember, when we talked about aggregate demand and aggregate supply, we talked about a notion of
our full employment output, which is you could view as a sustainable rate
of output for an economy and we can draw that as a vertical line, so this right over here would be our long run aggregate supply and where it intersects our real GDP axis, this is our full employment output, if you wanna put some numbers on it, maybe this is equal too
for a small economy, maybe this is equal to 50 billion dollars. So the way we’ve just described this, we are at equilibrium right now, we are at full employment output, our economy’s producing 50
billion dollars per year and our full employment output implies an unemployment rate of 4%, where we have 1% inflation. Now let’s say that there’s
some type of a demand shock, let’s say all of a sudden, the government wants to
stimulate the economy even beyond where it is
here and so you have a, and so they start
spending all of this money and so you have a shift in
the aggregate demand curve, so it would shift to the right, so the aggregate demand curve would now look something like this, let’s call that aggregate demand two, well, what happens now? And we’ve seen this in previous videos, now you have, we go from
this equilibrium point, which was at this full employment output and at this price level, let’s
call that price level one and now we are at this equilibrium point, people are demanding
more, so suppliers say, “Hey, if you want me to produce more, “I’m gonna charge you
some more for it too,” so our price level has gone up, we’re at price level two and we are producing above
full employment output, maybe this level right here is 60 billion, well, how would that be
reflected on our Phillips curves? Well, in the short run, our economy has gotten a
little bit above potential, so in the short run, so we would sit on the
short run Phillips curve and our unemployment rate would go down, but if we assume the Phillips curve, the short run Phillips curve model, that means our inflation would go up, so this point right over here might correspond maybe to
this point right over there, where when we get to that
beyond full employment output, let’s say that this is 60
billion right over here, well maybe our unemployment rate is 2% and our inflation rate here is 3%, now what happens next? Well, we’ve talked about this when we studied aggregate
demand and aggregate supply, workers, when it’s time for them to renegotiate their contracts will say, “Hey, prices have gone
up, I’m not going to work “for the same amounts over the long run,” and so you have a shift to the left of the aggregate supply curve,
at any given price level, there’s going to be
less supply, less output and so if this shifts to the left, eventually the equilibrium point will go back to where
everything intersects with the long run aggregate supply curve, so the short run aggregate
supply curve shifts over there and then we would be back to
our full employment output, although our price level
would have gone even higher, price level three. Now many economists would argue
that when you have a shift in the short run aggregate supply, so this would be short
run aggregate supply two, that that also is associated with a shift in our short run Phillips curve, because of these price increases and because workers are trying to renegotiate their salaries upwards and labor is the biggest
factor in price levels, you might have increased
inflation expectations, so then the given rate of inflation, you might start having
a higher unemployment and so this short run Phillips curve could shift to the
right, so instead of this just gravitating back
to where it was before, the whole curve could shift to the right and we get to a situation
that looks like this, where our inflation is still at 3%, but we are back to the long run unemployment rate of this economy.

10 thoughts on “Long run and short run Phillips curves

  1. I still don't understand why philips curve would shift to the right!

    Doesn't make sense to me, with higher inflation, there would be unemployment!

  2. On the AD/AS diagram the final inflation rate is higher than the final inflation rate on the Philips diagram…

  3. You are a life saver! I'm having a horrible time taking macroeconomics, never mind getting my head around this Philips curve concept. You've managed to break down some invisible wall that was blocking the receptors in my brain from picking up this mysterious economic frequency…. but seriously , this was by far the best explanation in a video that I could find!

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