The Short-Run Phillips Curve

Picture the economy heating up. Aggregate demand shifts right: firms sell more, so they hire more workers, pushing unemployment down. But those same firms also face rising costs for labor and materials, and they raise prices to cover them. One shock to aggregate demand produces two readings at once: a lower unemployment rate and a higher inflation rate. Plot those two outcomes together and you get a downward-sloping short-run Phillips curve. Moving along it is not a separate event from the aggregate demand shift; it IS that shift, translated into unemployment and inflation terms instead of output terms.

It is tempting to read the curve as a menu: pick 2 percent unemployment, pay 4 percent inflation, done forever. That fails because the curve itself is drawn for a given level of expected inflation. Once workers and firms see inflation running higher than they expected, they build that expectation into wage demands and pricing. The short-run curve shifts outward, and the old low-unemployment point now comes with even higher inflation. The tradeoff was only ever temporary. If aggregate demand collapses instead of rising, the whole story runs in reverse: output and hiring fall, unemployment rises, and inflation drops, a movement down and to the right along the same short-run curve.

This sets up the long-run Phillips curve: once expectations fully adjust, the economy returns to its natural rate of unemployment regardless of the inflation rate, so the long-run curve is vertical. Unit 5 uses that contrast to explain why policymakers cannot permanently exploit the short-run tradeoff without accelerating inflation.