Chapter 14, Problem 1E

To determine

To explain:

The difference between short-run and long-run phillips curve with the help of an aggregate supply and demand diagram.

Explanation of Solution

At natural rate of unemployment, the long-run Philips curve is a straight line; however, a short-run Philips curve is a L-shaped curve.

The difference between the short-run Philips curve and long-run Philips curve is shown in the diagram below:

On the left, the Aggregate Demand (AD) increases from AD1 to AD2, as the result of an increase in government spending. This increases aggregate income (Y) in the short run and the price level (P) rises. However, in the long run, Aggregate Supply (AS) decreases from AS1 to AS2 because of higher input costs due to inflation and the price level rises again.As a result, Long Run Aggregate Supply (LRAS) is fixed.

On the right, the increases in the price level translate to higher inflation. This leads to lower rates of unemployment (U) in the short run. Starting at a point a, the curve moves to point b. However, as Aggregate Supply decreases, the Short-Run Philips curve shifts up. Moving from point b to point c, the inflation stays high and the unemployment increases. In the long run, the unemployment is fixed with respect to the inflation rate.

Economics Concept Introduction

Philips Curve:

Phillips curve is a graphical representation of the relationship between inflation rate and unemployment. This curve states that there is an inverse relationship between inflation and unemployment.

Aggregate demand:

Aggregate demand is the total demand for final goods and services at a given time.

Aggregate supply:

Aggregate supply is the total supply of goods and services available in a market place.