- Long-run Phillips curve
- The long-run Phillips curve is a vertical line at the natural rate of unemployment, showing no long-run trade-off between inflation and unemployment.
- Short-run Phillips curve
- The short-run Phillips curve slopes down, showing a trade-off between unemployment and inflation that holds for periods of several years.
Where unemployment settles, and how people form expectations
Can you name two ideas about the long-run rate of unemployment and the two theories of expectations?
The long-run curve rests on two ideas: a rate of unemployment the economy returns to, and expectations that catch up with inflation.
The natural rate of unemployment is the rate of unemployment that would remain if the economy were neither booming nor in recession.
Can you think of an example?
Even in a strong economy some people are between jobs and some lack the skills employers want, so unemployment never reaches zero.
The NAIRU is the rate of unemployment at which inflation neither speeds up nor slows down, so holding unemployment below it makes inflation keep rising.
Can you think of an example?
If the NAIRU is about four per cent, holding unemployment at three per cent means inflation rising year after year, not settling at a higher rate.
Adaptive expectations are formed by looking at past experience and gradually adapting beliefs as circumstances change.
Can you think of an example?
After two years of five per cent inflation, workers start to ask for pay rises of five per cent, because that is what prices have been doing.
Rational expectations are the most accurate forecasts people can make about the future using all the information available to them.
Can you think of an example?
Told the government will boost demand, firms and workers expect higher prices straight away and raise them now, so output hardly changes.