Question

What is the difference between the short-run Phillips curve and the long-run Phillips curve? Use an aggregate supply and demand diagram to explain why there is a difference between them.

Short answer

Answer: The main difference between the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC) is that the SRPC shows an inverse relationship between unemployment and inflation in the short run, while the LRPC indicates that there is no trade-off between unemployment and inflation in the long run. In the aggregate supply and demand diagram, shifts in aggregate demand cause movements along the SRPC in the short run, while the LRPC represents the relationship between inflation and unemployment at the equilibrium when the economy reaches its natural rate of unemployment. This difference is due to the adjustment process of the economy, with businesses and workers having limited flexibility to adjust prices and wages in the short run, but adjusting fully in the long run causing the LRPC to be vertical.

Step-by-step solution

Introduction to Phillips Curve

The Phillips Curve represents the relationship between the rate of inflation and the rate of unemployment in an economy. It is based on the idea that when the economy is growing, more people are employed, leading to an increase in inflation. Conversely, when the economy is contracting, there is higher unemployment, leading to lower inflation. There are two types of Phillips curves: the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC).

Short-Run Phillips Curve (SRPC)

The short-run Phillips curve represents the short-term relationship between inflation and unemployment. In the short run, there is generally an inverse relationship between unemployment and inflation. As unemployment falls, inflation tends to rise, and vice versa. This relationship is often attributed to the fact that in the short run, businesses and workers have limited flexibility to adjust their prices and wages, leading to short-term fluctuations in inflation and unemployment.

Long-Run Phillips Curve (LRPC)

The long-run Phillips curve represents the relationship between inflation and unemployment when the economy is at its natural rate of unemployment (the non-accelerating inflation rate of unemployment, or NAIRU). In the long run, there is no trade-off between inflation and unemployment, and the curve is vertical. This means that, in the long run, the level of unemployment has no effect on the inflation rate.

Aggregate Supply and Demand Diagram

To explain the difference between the SRPC and the LRPC, we can use an aggregate supply and demand diagram. Here, the aggregate demand curve represents the total demand for goods and services in the economy, while the aggregate supply curve shows the total supply of goods and services. The intersection of these two curves determines the equilibrium level of output and the price level in the economy.

Relationship Between the Phillips Curve and Aggregate Supply and Demand

In the short run, when the economy is not in equilibrium, shifts in aggregate demand cause movements along the SRPC. For example, an increase in aggregate demand leads to higher output, lower unemployment, and higher inflation. However, in the long run, the economy reaches equilibrium, and the LRPC represents the relationship between inflation and unemployment at this equilibrium.

Why There Is a Difference Between SRPC and LRPC

The main difference between the SRPC and the LRPC is that the SRPC depicts the inverse relationship between unemployment and inflation in the short run, while the LRPC shows that there is no trade-off between unemployment and inflation in the long run. The reason for this difference lies in the adjustment process of the economy. In the short run, businesses and workers have limited flexibility to adjust prices and wages, making the trade-off between unemployment and inflation apparent. However, in the long run, as prices and wages adjust, the trade-off disappears, and the economy reaches equilibrium at its natural rate of unemployment, causing the LRPC to become vertical.