Principles of Economics/Philips

Fig - 1. Short and long run Philips Curve with shift in short run.

Short Run Philips Curve

The Short run Philips curve is down-ward sloping, showing an inverse relationship between unemployment (u) and inflation. A decrease in interest rates can only be brought about by an increase in interest rates (another reason why Economics is a dismal science - just wait, it gets worse). At any time, the government/Central Bank can determine which interest rate to use, and the economy will adjust to have the unemployment rate that meets the curve at that interest rate.

Long Run Philips Curve

The Long run Philips curve is perfectly vertical, the idea being that in the long run, the Philips curve will assume that form. If the government stays at any point on the short run Philips curve for any significant period of time, people will begin to expect that particular rate of inflation and wages will increase to adjust for that expectation, spurring another round of inflation. This increases the inflation process, raising the inflation rate. To mirror this, the short run Philips curve shifts rightward (with low levels of unemployment and high interest rate) until the point the economy reaches the long run Philips curve (a shift from SRPC1 to SRPC2).

Vicious Spiral Upward

As a result of this shift, the new position involves just as high an interest rate as before, but the unemployment rate has returned to its natural position. The natural unemployment rate is the rate of unemployment that would cause no shift in the short run Philips Curve, and is somewhere around 10%. This is, for most political situations, an unacceptably high unemployment, hence the need to artificially reduce it by increasing interest rate. Hence, the economy enters a spiral in which interest rates continually increase for only temporary decreases in unemployment (told you it gets worse).

Vicious Spiral Downward

The opposite is also true. If the government persistently sets the interest rate below the position where the short and long run Philips curves cross, then there will be higher than normal unemployment. If this is held for a significant period of time, the short run Philips curve will begin to shift downward, resulting in continually decreasing inflation for temporarily higher-than-normal unemployment. However, the suffering that such an economic policy, while effective, would bring to people is politically unpopular, and the general trend has been to rising inflation rates.