View source for Long Run Phillips Curve

The '''long-run Phillips curve''' expresses the relationship between inflation and unemployment when expectations have fully adjusted, so that there is no trade-off between the two. It is vertical at the natural rate of unemployment, also called the non-accelerating inflation rate of unemployment, meaning that any rate of inflation is consistent with that unemployment rate in the long run. The concept distinguishes the long run, in which expectations adjust fully, from the short run, in which a trade-off may exist because expectations are slow to change.

== The expectations argument ==

The argument for a vertical long-run Phillips curve rests on the role of expectations. In the short run, an increase in demand raises prices and wages, and if workers and firms do not immediately recognise that this reflects inflation rather than a real improvement, employment and output rise and unemployment falls. The temporary reduction in unemployment reflects the gap between actual and expected inflation, a phenomenon described as the inflation surprise.

Over time, expectations adjust. Workers come to expect higher inflation, and they demand higher wages to protect their purchasing power. As wages rise, the initial gain in employment is eroded, and unemployment returns to its natural rate, but at a higher rate of inflation. The short-run Phillips curve therefore shifts upward as expectations adjust, and the long-run relationship, traced through successive short-run curves, is vertical at the natural rate.

== The natural rate ==

The natural rate of unemployment is the rate consistent with stable inflation when expectations are fulfilled. It reflects the structural and institutional features of the labour market, including the efficiency of matching, the level of benefits relative to wages, the coverage of collective bargaining, and the extent of regulation. It is not fixed but can change with policy and with the structure of the economy.

The natural rate can be estimated by comparing inflation across different levels of unemployment and identifying the rate at which inflation is stable. Estimates are imprecise, and the rate can shift over time, which complicates policy. Nonetheless, the concept is central to the analysis of monetary policy, because an attempt to hold unemployment below the natural rate will generate accelerating inflation, while a rate above it will generate decelerating inflation.

== Policy implications ==

The vertical long-run curve implies that monetary policy cannot permanently reduce unemployment. Any attempt to keep unemployment below the natural rate will generate accelerating inflation, as each attempt to lower unemployment requires an ever-larger inflation surprise, and expectations chase actual inflation. This insight, associated with Milton Friedman and Edmund Phelps and confirmed by the experience of the 1970s, changed the conduct of monetary policy.

The implication is that policy should aim to stabilise inflation and to reduce the natural rate, rather than to exploit a long-run trade-off that does not exist. Structural policies, including education and training, labour market reform, and measures to improve matching, can lower the natural rate and thereby reduce unemployment sustainably. Monetary policy, by contrast, can stabilise inflation and output around the natural rate but cannot change the rate itself in the long run.

== Short-run versus long-run ==

The distinction between the short run and the long run is essential. In the short run, when expectations are fixed or slow to adjust, there may be a trade-off between inflation and unemployment, and monetary and fiscal policy can influence output and employment. The trade-off is temporary, and its exploitation leads to rising inflation without a permanent gain in employment.

The length of the short run depends on the speed of expectation adjustment and on the credibility of policy. Where the central bank is credible and expectations are well anchored, the short-run trade-off may be small, because expected inflation does not move much in response to policy. Where credibility is weak, expectations adjust quickly and the short-run gains are brief. This interaction between credibility and the trade-off informs the design of monetary policy frameworks and the importance of communication.

== The accelerationist hypothesis ==

The vertical long-run curve is associated with the accelerationist hypothesis, which holds that there is no permanent trade-off between inflation and unemployment and that an attempt to hold unemployment below the natural rate results in accelerating inflation. The hypothesis implies that the inflation rate changes in response to the gap between actual and natural unemployment, so that a persistent gap generates ever-rising inflation, which is why the natural rate is also called the non-accelerating inflation rate of unemployment.

The hypothesis was confirmed by the experience of the 1970s, when many economies experienced both high inflation and high unemployment, a combination that the simple Phillips curve could not explain. The stagflation of that period, and the disinflation that followed in the 1980s, showed that the trade-off was temporary and that expectations adjusted, vindicating the view that the long-run curve is vertical and that credibility matters for the cost of disinflation.

== The role of credibility ==

The cost of disinflation depends on credibility. If the central bank is believed to be committed to lowering inflation, expectations adjust quickly and the output cost is small, because wages and prices are set with lower expected inflation. If the commitment is not credible, expectations adjust slowly, and the central bank must keep demand weak for longer, imposing a larger cost in terms of unemployment. Institutional arrangements that enhance credibility, including central bank independence and clear targets, can therefore reduce the cost of disinflation.

The importance of credibility explains the emphasis on communication and on frameworks in modern monetary policy. By announcing a target and explaining its decisions, the central bank seeks to anchor expectations so that inflation can be controlled at lower cost. The experience of successful disinflations, in which inflation fell with limited output loss, supports the view that credibility is a central determinant of the trade-off between inflation and unemployment.

== Hysteresis and the natural rate ==

A further complication is that the natural rate may not be independent of actual unemployment. If a prolonged period of high unemployment leads workers to lose skills, to become discouraged, and to leave the labour force, the natural rate itself may rise, a phenomenon called hysteresis. In that case, a deep or prolonged recession can have permanent effects, and demand management may affect the long-run level of employment, not only the short-run deviation from it.

Hysteresis has important implications for policy. It suggests that prompt and effective action to support demand during recessions may be necessary not only to stabilise output in the short run but also to prevent permanent damage to the labour market. It also means that the natural rate is not a fixed parameter but a variable that can be affected by policy, and that estimates of the natural rate should be treated with caution, since they may change over time in response to the path of the economy.

== See also ==

* [[Phillips Curve]]
* [[Natural Rate of Unemployment]]
* [[Inflation Expectations]]
* [[Monetary Policy]]
* [[Rational Expectations]]

== References ==


<ref name="r1">Macroeconomics textbooks on inflation and unemployment.</ref>
<ref name="r2">Central bank research on expectations and the natural rate.</ref>
<ref name="r3">OECD work on labour market institutions.</ref>
<ref name="r4">Journal literature on the Phillips curve.</ref>

<references />