Question

Assume there is a particular short-run aggregate supply curve for an economy and the curve is relevant for several years. Use AD-AS analysis to show graphically why higher rates of inflation over this period will be associated with lower rates of unemployment and vice versa. What is this inverse relationship called?

Short answer

The following diagram shows a rise in both price level and GDP level and the relation between unemployment and price:

The inverse relation between the inflation rate and unemployment rate is known as the Philips curve in the short run.

Step-by-step solution

The link between the AD-AS model and the Philips curve 

The AD-AS model establishes a price and GDP level relationship. It also explains that as aggregate demand shifts rightward, the price level and GDP level rise in the economy. A rise in GDP level corresponds to higher employment and a decline in the unemployment rate. Thus, inflation rate and unemployment rate are negatively correlated in the short run. This inverse relationship between the inflation rate and the unemployment rate is known as the short-run Philips curve.

The illustration of Philips curve 

The following figure illustrates the short-run tradeoff between the inflation rate and the unemployment rate.

According to the above figure, the price level rises from P_fto P₁,and the output level rises from Q_fto Q₁due to the rightward shift of the aggregate demand curve. At E₁, the actual output is higher than the potential (or full-employment) output. It implies that corresponding to E₁, the actual unemployment rate should be lower than the natural rate.

Therefore, as the inflation rate increases from P_fto P₁, the unemployment rate falls from u_fto u₁.

Hence, the inflation rate and unemployment rate are negatively sloped in the short run, and the Philips curve is downward sloping, as shown in the above figure.