Phillips Curve Notes for IB Economics HL: Short-Run Trade-offs and Long-Run

Curated by Kelvin Hong, founder of The Economics Tutor. Part of our Free Economics Notes series.

TL;DR

• The Concept: A model showing the relationship between inflation and unemployment.
• Short-Run Phillips Curve (SRPC): Shows a trade-off. You can lower unemployment, but you will suffer higher inflation (and vice versa). It is the mirror image of the AD/AS model.
• Long-Run Phillips Curve (LRPC): The Monetarist/New Classical view. In the long run, there is no trade-off. The LRPC is a vertical line at the Natural Rate of Unemployment (NRU).
• The Big Shift (Stagflation): A negative supply shock (like rising oil prices) shifts the entire SRPC outward, causing both high inflation and high unemployment simultaneously (breaking the original trade-off rule).

1. Core Theory: The Short-Run Phillips Curve (SRPC)n

In the 1950s, economist A.W. Phillips noticed a stable, inverse relationship between wage inflation and unemployment. When the economy is booming (Aggregate Demand is high), jobs are plentiful, so unemployment drops. However, to attract workers, firms must raise wages, which they pass onto consumers as higher prices (inflation).

The Rule: Demand-side policies (Fiscal or Monetary) only cause a movement along the SRPC.

The IB Translation: If a government uses expansionary fiscal policy to lower unemployment from 7% to 3% (moving from Point A to Point B), they must accept that inflation will rise from 2% to 6%.

2. The Monetarist Reality Check: The Long-Run (LRPC)

In the 1970s, the SRPC trade-off broke down. Monetarist economists like Milton Friedman argued that the trade-off only exists in the short run because workers suffer from “money illusion” (they think a 5% wage raise is great, forgetting inflation is at 6%).

Once workers realize their real purchasing power has dropped, they demand higher wages, increasing costs for firms, who then fire workers. The economy snaps back to the Natural Rate of Unemployment (NRU), but now with permanently higher inflation.

The Mechanism: Why the Trade-off Fails in the Long Run

The progression through Points A, B, and C explains why an economy cannot permanently maintain lower unemployment by accepting higher inflation.

1. Point A (Initial Equilibrium): The economy is resting on the Long-Run Phillips Curve (LRPC). Actual unemployment is at the Natural Rate (Un), and inflation is stable at π1. At this point, expected inflation exactly matches actual inflation.
2. Movement from A to B (The Short-Run Illusion): Policymakers initiate expansionary policies (e.g., increasing the money supply or government spending) to drive unemployment below the natural rate, to U1.
   • Why it works initially: Nominal wages are “sticky” in the short run. As prices rise to π2, real wages fall. Businesses find it cheaper to hire, so unemployment drops.
   • A short-run trade-off exists here: you get less unemployment for a penalty of higher inflation.
3. Movement from B to C (The Long-Run Adjustment): Workers eventually realize their real purchasing power has dropped due to the higher inflation rate (π2). They begin to demand higher nominal wages to compensate.
   • As wage costs rise for businesses, the initial incentive to hire disappears. Businesses start laying off the extra workers.
   • Inflation expectations adjust upward to π2, which geometrically shifts the entire Short-Run Phillips curve upward from SRPC1 to SRPC2.
4. Point C (New Equilibrium): The economy returns to the Natural Rate of Unemployment (Un). However, it is now saddled with the permanently higher inflation rate of π2.

Because unemployment always reverts to the Natural Rate (Un) once inflation expectations catch up with reality, the Long-Run Phillips Curve is completely vertical. Any attempt to exploit the trade-off only results in higher prices without any lasting employment benefits.

3. The Examiner’s Secret: Shifting the Curve

A classic trap for IB students is confusing a movement along the curve with a shift of the curve.

Economic Event	Impact on AD/AS	Impact on Phillips Curve
Central Bank cuts interest rates	AD shifts right	Movement UP along the SRPC
Government cuts income taxes	AD shifts right	Movement UP along the SRPC
Global oil prices double	SRAS shifts left	Entire SRPC shifts OUTWARD (Stagflation)
Government heavily subsidizes retraining	LRAS shifts right	LRPC shifts INWARD (NRU falls)

The Nightmare Scenario: Stagflation

When supply costs soar (e.g., an oil crisis), the SRAS curve shifts left. This causes the entire SRPC to shift outward. The economy now suffers from higher inflation and higher unemployment at the exact same time. The traditional trade-off is dead.

4. Past Year Essay Blueprints

To score a Level 3 (highest mark band) in your IB Economics Papers, you must evaluate the limits of macroeconomic models. Here is how to structure the most common Phillips Curve essays.

Blueprint 1: The Short-Run Trade-off [10 Marks]

“Explain, using a Phillips curve diagram, the short-run trade-off between inflation and unemployment.”

• The Approach: This is a standard Paper 1 Part (a) question.
  1. Define inflation and unemployment.
  2. Draw the SRPC (downward sloping).
  3. Explain the mechanism: High AD $\rightarrow$ labor shortages $\rightarrow$ firms raise wages to attract workers $\rightarrow$ firms raise prices to cover wage costs.
  4. Conclude that policymakers face a dilemma: to fix unemployment, they must accept inflation (and vice versa).

Blueprint 2: Monetarist vs. Keynesian Views [15 Marks]

“Evaluate the view that there is no trade-off between inflation and unemployment in the long run.”

• The Approach: This is a classic Paper 1 Part (b) evaluation.
  • Thesis (Keynesian): In the short-run, the trade-off is very real. If an economy is stuck in a deep recession, boosting AD will rapidly reduce unemployment with very little inflation penalty initially.
  • Anti-Thesis (Monetarist/New Classical): Explain the LRPC. Use a diagram to show how inflation expectations catch up (shifting the SRPC upward). Conclude that any attempt to push unemployment below the NRU only buys temporary jobs at the cost of permanent inflation.
  • Synthesis: The effectiveness of the trade-off depends on the time horizon. Demand-side policies work for short-term cyclical unemployment, but only supply-side policies can shift the LRPC to genuinely lower the natural rate of unemployment.

Want to see exactly how these blueprints are written out for Level 3 IB marks?

Perfecting your essay structure is the key to a 7. Join our IB Economics Tuition to get access to our complete database of full model essays, personalized grading, and one-on-one feedback.

5. Exam Traps & Misconceptions (The “How to Score” Section)

Master these common pitfalls to avoid losing unnecessary marks in Paper 1 and 2.

Trap 1: The “0% Unemployment” Trap

The Misconception: Students often write or draw the vertical Long-Run Phillips Curve (LRPC) at 0% unemployment.

The Correction: Zero unemployment is impossible and undesirable. The LRPC is vertical at the Natural Rate of Unemployment (NRU)—usually around 4% to 5%. This is the rate where cyclical unemployment is zero, but frictional and structural unemployment still exist.

Trap 2: The “Movement vs. Shift” Trap

The Misconception: Students use movement along the curve to explain all inflation.

The Correction: Movement along the SRPC only occurs with demand-side policy shocks (Fiscal or Monetary policy changing AD). If you want to explain Stagflation (high inflation + high unemployment simultaneously), you must explain that the entire SRPC shifts outward (usually due to a negative supply shock like oil prices).

Trap 3: The “Deflation vs. Disinflation” Trap

The Misconception: Stressed students often use these two terms interchangeably.

The Correction:

• Deflation is when prices are actually falling. The inflation rate is negative (e.g., -2%).
• Disinflation is when prices are still rising, but at a slower pace than before. The inflation rate is positive but falling (e.g., inflation drops from 6% to 3%).

Frequently Asked Questions (FAQ)

---