Answer to Question #167869 in Macroeconomics for Ashutosh

Question

What does the Phillips curve signify? How do you reconcile the difference in the shape of the curve in the short run and 

the long run?

Answer 1

The Philips curve signifies the relationship that exists between rate of unemployment and inflation.

The Phillips curve given by A.W. Phillips shows that there exist an inverse relationship between the rate of unemployment and the rate of increase in nominal wages.

The Phillips curve shows the inverse relationship between inflation and unemployment: as unemployment decreases, inflation increases.

A lower rate of unemployment is associated with higher wage rate or inflation, and vice versa. In other words, there is a tradeoff between wage inflation and unemployment.

Reason: during boom, demand for labor increases. Due to greater bargaining power of the trade union, wage increases.

The Phillip's curve is reconciled in the difference in the shape of the curve in the short run and  the long run in that:

The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis.

The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and unemployment are unrelated in the long run.

Now we can understand the differences between the short-run and long-run Phillips curves. In the short run, an increase in Aggregate Demand does move the economy up to the left along the short-run Phillips curve. Output and inflation increase while unemployment decreases. Over the longer term, however, inflation expectations increase and workers no longer work the extra hours because they realize that real wages have not increased with the increase in prices. Output returns to the same level as before but inflation is higher because it is built into the system in terms of higher inflation expectations. The long run Phillips curve, therefore, is vertical.