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The Phillips Curve
The Phillips Curve shows the relationship between the rate of unemployment and the rate of inflation. We can see that empirically when unemployment is low inflation is high and vice versa. This means there is a trade off between unemployment and inflation.
The reason for this is that when the demand for labour is high (thus unemployment is low) firms will be prepared to bid up wages in order to attract labour. This will result in higher wages being passed on in the form of higher prices causing a rise in price levels (inflation). 
This means that policies with the intent to reduce inflation may lead to higher unemployment.  

Expectations Augmented Phillips Curve
Some argue that the Phillips curve is a short run phenomenon and in the long run there is a natural rate of unemployment. The reason for the existence of this long run Phillips curve is because of expectations.
On the graph to the left, the economy starts at position A with inflation π0 and unemployment of Unat. However the government wants to reduce unemployment further and tries to increase inflation in order to reduce unemployment. People see higher wages (as a result of inflation) but don’t immediately realise that the price of goods is also rising (and therefore real wages are relatively constant). Therefore some people may enter the workforce, or accept jobs, because they believe they will receive larger incomes. Hence there is a shift from A to B with inflation higher at π1 and unemployment falls to U1.

However, eventually people realise that the increase in wage rates is a result of inflation and that in real terms they aren’t any better off. This results in a return to the long run Phillips curve and a rightward shift of the short run Phillips curve. It now takes even more inflation for unemployment to decrease. Hence in the long run the attempt to reduce unemployment below Unat has just caused increased inflation. The natural rate of unemployment is also known as the non-accelerating inflation rate of unemployment (NAIRU).
There is then the difficulty of getting back to the original inflation rate. This will only occur if people expect lower inflation. Unemployment will increase as inflation falls and there is a downward movement along the short run Phillips curve. However the time taken for this re-adjustment to occur can be costly due to high unemployment. 
Page last updated on 15/04/14