Question

How would a decrease in energy prices affect the Phillips curve?

Short answer

A decrease in energy prices would result in a decrease in inflation, as businesses face lower production costs and pass these savings onto consumers in the form of lower prices. In relation to the Phillips curve, this decrease in inflation would typically lead to a higher unemployment rate, causing the curve to shift upwards. Thus, the Phillips curve is sensitive to external factors such as energy prices, which can cause shifts in the relationship between inflation and unemployment within an economy.

Step-by-step solution

Understand the Phillips Curve

The Phillips curve is a graphical representation of the inverse relationship between inflation and unemployment within an economy. The idea is that as inflation increases, unemployment decreases and vice versa. The curve is typically downward-sloping, which means that when inflation is high, unemployment is low, and when inflation is low, unemployment is high.

Analyze the effect of decreased energy prices on inflation

A decrease in energy prices generally causes a reduction in the overall cost of production for firms. As energy prices decrease, the businesses face lower costs, and that often leads to lower prices for goods and services. This decrease in prices is essentially a decrease in the inflation rate.

Understand the effect of lower inflation on the Phillips Curve

With the decrease in inflation due to lower energy prices, we would expect a shift in the Phillips curve. Since the relation between inflation and unemployment is inverse, a decrease in inflation would typically result in a higher unemployment rate. Therefore, the Phillips curve would shift upwards to reflect this change.

Conclusion

A decrease in energy prices has an impact on the Phillips curve by lowering inflation, and thus shifting the curve upward due to an increase in unemployment. This demonstrates that the Phillips curve is sensitive to changes in external factors such as energy prices, which can cause shifts in the relationship between inflation and unemployment within an economy.