Relationship between Short Run and Long Run Phillips Curves

Relationship between Short Run and Long Run Phillips Curves –

The position of a short run Phillips curve (SPC) which passes through a point on the long run Phillips curve (LPC) depends on the anticipated inflation rate.

Short run Phillips curve is like the short run aggregate supply curve (SAS) which is drawn with a given expected price level. Short run Phillips curve is also drawn with an anticipated (expected) inflation rate and it will shift as the expected inflation rate changes.

If the expected inflation rate is 9 percent a year, then, the short run Phillips curve SPC₀ passes through the corresponding point A on the long run Phillips curve (LPC) with natural unemployment rate of 5 percent. The movement along short run Phillips curve occurs as a result of changes in aggregate demand. When there is unanticipated increase in aggregate demand, inflation rate rises more than the expected rate and GNP increases causing a fall in unemployment rate, we move upward to the left from point A on the short run Phillips curve SPC₀. On the other hand, when there is unanticipated decrease in aggregate demand, inflation rate falls and unemployment rate increases above the natural rate and as a result we move downward to the right from point A along the short run Phillips curve SPC₀.

However, When the expected inflation rate changes, the short run Phillips curve shifts. For example, when the expected inflation rate is 9 percent a year, the short run Phillips curve is SPC₀ in fig. 13.9. If the expected inflation rate falls to 6 percent a year, the short run Phillips curve shifts below to SPC₁. The new short run Phillips curve passes through long run Phillips curve at the new expected inflation rate of 6 percent. The distance by which the short run Phillips curve shifts to a lower position is equal to the change in the expected rate of inflation.

Now, the question arises – Why the short run Phillips curve shifts downward when the expected inflation rate falls ?

To begin with, the expected inflation rate of 9 percent a year prevails. To check this inflation rate the Central Bank of a country will take steps to lower the growth in money supply. As a result, actual inflation rate falls to 6 percent a year.

At first the fall in actual inflation rate is anticipated and therefore the wages and other input prices continue to rise at their original rate consistent with 9 percent expected inflation rate and there is rightward movement along the short run Phillips curve SPC₀ resulting in fall in GNP and increase in unemployment rate.

However, when the inflation rate remains steady at 6 percent a year, this rate eventually comes to be anticipated. As this happens, increase in wage rate and other input prices slows down and with the expected increase in aggregate demand, GNP increases and unemployment rate falls to the natural level. As a result, the short run Phillips curve shifts downward to the new position SPC₁ that corresponds to the new lower expected inflation rate of 6 percent a year.