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The Phillips Curve in the Short Run: Economic Behavior

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  • 0:05 Economic Behavior
  • 0:41 In a Weak Economy
  • 2:33 In a Strong Economy
  • 3:54 Lesson Review
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Economists have ways to describe the changes in the economy. In this lesson, discover the short-term relationship between inflation and unemployment - what economists refer to as the Phillips Curve.

Phillips Curve in the Short Run: Economic Behaviors

Imagine with me that five years ago, Bob's low-rider lawn service started out the year mowing 100 lawns per week. Most of the time, let's say Bob needs 10 workers to accomplish this task. They spend their days mowing small lawns, big lawns and medium-sized lawns. While they mow, they listen to music on their Me-Pods, and listen to podcasts about the principles of effective lawn mowing. I've heard that occasionally Bob has to talk with one or two of the workers because he catches them texting while mowing.

The Phillips Curve in a Weaker Economy

Now the economy falls into recession, and Ceelo begins to feel the effects. Some of Bob's customers decide to cut their budgets and cut their own lawns personally. So, they call up Bob and cancel their lawn service. As a result, Bob is only mowing 75 lawns instead of 100. Responding to a slower economic climate, Bob decides to lay off 3 of his workers, so that he has fewer than his usual 10 workers. He also decides to lower the price of his service in order to attract new customers. When businesses across the economy do the same thing, unemployment rises above its natural rate. At this point in time, we find that the unemployment rate is high and prices (or inflation) are low.

Economists call the relationship between inflation and unemployment the Phillips Curve. As you can see, unemployment moved up and prices moved down. There is a definite tradeoff between unemployment and inflation - at least in the short run. The scenario I just talked about is what happens to economies in the short run, and it can be illustrated as movement along the Phillips Curve in the downward direction, from point A to point B. Economists call it 'moving down the Phillips Curve.'

Here's how economists would describe it: when aggregate demand falls, the economy settles at a new macroeconomic equilibrium at a lower price and lower level of output. Firms respond by laying off workers, so unemployment rises above its natural rate. This corresponds to a movement down the Phillips Curve, as you can see here.

The downward direction of the Phillips curve reflects high unemployment and lower inflation
Phillips Curve Moving Down

The Phillips Curve in a Stronger Economy

Let's look at things from the opposite point of view. Imagine with me that this year Bob's low-rider lawn service begins the year mowing 100 lawns per week. Most of the time, let's say Bob needs 10 workers to accomplish this task. Shortly thereafter, the economy is expanding rapidly. Bob's work force is very busy, not sending texts but mowing lawns. Because of this strong economy, Bob hires 5 more workers, and unemployment goes down. He now is able to mow 150 lawns per week instead of 100. Since there is extra demand in the economy, this leads to higher prices. Here we can see the tradeoff between unemployment and inflation again, in the short run. When unemployment falls, inflation rises. This short run event is illustrated as movement along the Phillips curve in the upward direction, from point A to point B.

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