Question

Within the Phillips curves, how does inflation affect unemployment and vice versa?

Answer 1

On the short-run Phillips Curve, inflation and unemployment vary inversely -- but the long-run Phillips Curve demonstrates that we really can't trade-off high inflation for low unemployment for long.

Explanation:

In the short run, the central bank can stimulate the economy with monetary expansion. As the economy reacts in the short run to additional liquidity, unemployment falls, but inflation increases as a result of monetary expansion. The economy moves from A to B on the initial Short-Run Phillips Curve.

Unfortunately, lenders and investors figure out what the central bank is doing and adjust to expectations of higher inflation. Once the market has a higher expected rate of inflation, a new Short-Run Phillips Curve describes the new trade-offs between inflation and unemployment, and the economy moves to C.

If the central bank continues to try more expansionary monetary policy, it will find itself in an inflationary spiral, moving "up" a Short-Run Phillips Curve to the desired lower unemployment, only to find that unemployment returns to higher levels on yet another (higher) Short-Run Phillips Curve.

The Long Run Phillips Curve is vertical at NAIRU, the Non-Accelerating Inflation Rate of Unemployment. In other words, the Long Run Phillips Curve reflects monetary neutrality -- the inability of monetary policy to engineer a permanently lower rate of unemployment.

The long-run rate of unemployment will be impacted by factors like savings and investment. Some economists would argue that trying to move along a Short Run Phillips Curve will discourage savings and investment, thereby impeding long run growth and actually leading to a NAIRU that will increase to reflect lower levels of capital investment in the future.