The Phillips Curve

Many policy makers aim toward low unemployment and low inflation, however these two goals do not directly work hand in hand.  The Phillips Curve describes the relationship between inflation and unemployment with relation to the Short-Run Aggregate Supply Curve.  When the economy moves up the SAS curve toward a higher price level and a higher output this reduces unemployment.  However, since there is a higher price level, this increases inflation.  Thus, in order to get lower unemployment rates, a rise in inflation must be sacrificed.  The Phillips Curve is made up of an equation with several parts:

 

= e - (u - u) + 

Where:

= Inflation

e = Expected Inflation

  is a parameter that measures the response of inflation with relation to cyclical unemployment

(u - u ) = Cyclical Unemployment

= Supply Shocks

This equation shows that unemployment is related to inflation and movements in the inflation rate.  This parallels the relationship between output and price level which is reflected in the Short-Run Aggregate Supply Curve.

Inflation can often be determined by two things:

• Rational Expectations

• Adaptive Expectations

Another important thing to look at when discussing the Phillips Curve is the sacrifice ratio.  This is the percentage of a year's real GDP that must be given up in order to reduce inflation by 1 percentage point.  The typical estimate of this ratio is 5 percent of the GDP must be given up in order to reduce inflation by 1 percent.

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