Expectations catch up

The chain in words

1. Step 1

   Before the boom

   The horizontal axis is the unemployment rate. The vertical axis is the inflation rate. The economy sits at A₀, where the short-run Phillips curve crosses the vertical long-run curve at the natural rate.

2. Step 2

   The boom moves along the curve

   A demand boom has pushed unemployment below the natural rate. The economy is up and to the left along the SRPC, with higher inflation. Workers notice.

3. Step 3

   The short-run Phillips curve shifts right

   Workers build the higher inflation into wage demands and firms into price plans. At every unemployment rate, inflation is now higher than before, so the short-run Phillips curve shifts right.

4. Step 4

   Back at the natural rate, higher inflation

   As the boom fades, unemployment returns to the natural rate, but along the new, higher curve. The economy ends at A₁ on the LRPC: the same unemployment as at A₀, with permanently higher inflation. The short-run gain in jobs is gone.

Takeaway. When expected inflation rises, the short-run Phillips curve shifts right and the economy returns to the natural rate at higher inflation.

Draw it yourself

More on the phillips curve graph