Friedman’s and Phelps’s analysis distinguishes between the “short-run” and “long-run” Phillips curves. Inflation is inversely related to unemployment if inflation remains fairly constant, but when the average rate of inflation changes, after a period of adjustment unemployment returns to the natural rate of unemployment. The faster the expectations of inflation adjusts, the faster unemployment falls to the natural rate and the less successful the government is in reducing unemployment through monetary and fiscal policy (Hoover, n.d.).
The long-run relationship is as a vertical line above the natural rate of unemployment. “There is no stable long-run trade-off between inflation and unemployment: policy-makers cannot, in the long-run, “pay” for lower unemployment with a little bit of inflation” (The Inflation Acceleration Controversy, n.d.).
In the short run policy makers can exploit the inflation unemployment trade off but it could have long run costs of high inflation with no gains. Suppose government wants to target unemployment rate of U1, as discussed above this would result in moving to point a in figure 3 where unemployment is U1, and inflation is π1. Adaptive expectations would result in the Philips Curve shifting upwards, unemployment would return to U* and government’s effort of maintaining unemployment at U1 would be unsuccessful. If government wanted to bring unemployment back to U1 they would have to further increase aggregate demand and the economy would move from ‘point b’ to ‘point c’. Unemployment would be at U1 but inflation would be at a higher level of π2. Adaptive expectations would again cause the Philips curve to shift upwards, economy would move to ‘point d’, unemployment would return to the natural rate but with a much higher level of inflation.
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