Explaining The Short- Run Policy Trade-Off

The short-run Phillips curve (SRPC) is used to show the relationship between inflation and unemployment given constant rates of both expected inflation and natural unemployment. Graphing the unemployment rate on the horizontal axis and the inflation rate on the vertical axis, the SRPC is a downward sloping curve. Inflation and unemployment have an inverse relationship over the short term. As you move along the SRPC, higher inflation leads to lower unemployment. Because events and factors change over the long term, the long-run Phillips curve (LRPC) shows the relationship between inflation and unemployment when the economy is at full employment. Graphically, the long-run Phillips curve is vertical at the natural unemployment rate.

In the long run, higher or lower inflation has no effect on the unemployment rate. You forecast the expected inflation rate and use it to set the money wage rate and other money prices. You use data about past inflation and other relevant variables to predict future inflation. From the AS-AD model, the money growth rate determines the growth of aggregate demand in the long run. Aggregate supply in the long run is determined by the growth rate of real GDP. With this understanding, you can see how expectations for inflation are formed.

This resource provides instruction for users to:

• Explain the relationship between inflation and unemployment using the short-run Philips curve
• Compare the short-run and the long-run Phillips curves
• Explain the effect of the Federal Reserve policies and actions on the short-run trade-off