- Define the concept of Phillips curve
- Recall the short run/long run Phillips curve
- Explain the Phillips Curve concept using aggregate supply/aggregate demand and the output gap
- Explain the factors that influence short run/long run aggregate supply and real GDP
- Explain movement along the long-run and short-run aggregate supply curves
In the late 1950's, an economist working in England named Phillips published a study of inflation and unemployment rates. He found that there was an inverse relationship between unemployment and inflation.
The Phillips curve shows the relationship between the inflation rate and the unemployment rate. In the short run, there is an inverse relationship between inflation and unemployment. There is a tradeoff: more unemployment means less inflation while less unemployment means a higher inflation rate.
An increase in aggregate demand moves the economy up the Phillips curve; the economy experiences a lower unemployment rate along with a higher inflation rate.
A decrease in aggregate demand moves the economy down the Phillips curve: a lower inflation rate but a higher unemployment rate.
A supply shock shifts the Phillips curve up to the right.
Policymakers in the 1960's believed that there was a permanent tradeoff between unemployment and inflation. By manipulating aggregate demand, policymakers could achieve any combination of unemployment and inflation along the Phillips curve. Once that point had been reached, the economy would stay there until there was a change in economic policy.
Natural Rate Hypothesis
Inflation has its own inertia. Inflation tends to chug along at the same rate until a shock hits the economy. Then, the inflation rate moves around but eventually starts moving along at the same rate from year to year. Because the inflation rate tends to be inertial, the inflation rate becomes expected. The expected inflation rate is the rate of inflation that is expected and built into contracts.
During the late 1960's, Phelps and Friedman separately put forward the natural rate hypothesis. The natural rate hypothesis distinguishes between long run and short run Phillips curves and argues that there is no long run tradeoff between unemployment and inflation.
According to the natural rate hypothesis, the inflation rate depends on both the unemployment rate and the expected rate of inflation. There is a different short run Phillips curve for each expected inflation rate. 
When the actual inflation rate equals the expected rate, the economy will be at its natural unemployment rate. 
Suppose policymakers decide to increase AD in order to lower the unemployment rate to U1. The economy moves from point A to point B. However, the inflation rate is now 5%, higher than the 4% that was expected. As long as people continue to expect 4% inflation the economy will remain at point B and there will be a stable tradeoff between unemployment and inflation.
But, eventually people will begin to expect the higher inflation they have been experiencing. Once people expect 5% inflation, the short run Phillips curve shifts up. If the unemployment rate remains at U1, the actual inflation rate will be 8%, not the 5% people had expected. Inflation expectations will be revised again and the short run Phillips curve shifts up.
There is no longer a nice, stable tradeoff between unemployment and inflation.
- when the unemployment rate is below its natural rate, the result is higher and higher inflation rates
- when the unemployment rate is above its natural rate, the result is ever decreasing inflation rates
The economy is in long run equilibrium when the inflation rate does not change. The long run Phillips curve traces out all the points of long run equilibrium. It is vertical at the natural rate of unemployment. In the long run, there is no tradeoff between unemployment and inflation.
Inflation and Expectations
The Central Bank reduces inflation by slowing money growth. The economy moves down the SRPC and a recession occurs. 
The costs of reducing inflation depend on how quickly inflation expectations (and the short run Phillips curves) fall.
