This material sits in the exam's heaviest content area — Inflation, Unemployment, and Stabilization Policies (20–25% of the CLEP exam).
In 1958, A.W. Phillips plotted a century of British data and found that when unemployment was low, wage inflation was high, and vice versa. The short-run Phillips curve (SRPC) captures that pattern: inflation on the y-axis, unemployment on the x-axis, sloping downward.
The SRPC is not a new theory — it is the AD-AS model re-graphed: - AD shifts right along SRAS → output rises (unemployment falls) and the price level rises faster (inflation rises). On the SRPC, the economy slides up and to the left. - AD shifts left → output falls (unemployment rises), inflation cools. The economy slides down and to the right.
Every point on the SRPC corresponds to a possible AD-SRAS intersection. AD-AS speaks in (price level, output); the Phillips curve speaks in (inflation, unemployment).
| AD-AS event | Phillips curve result |
|---|---|
| AD shifts right | Movement up-left along the SRPC |
| AD shifts left | Movement down-right along the SRPC |
| SRAS shifts left (negative supply shock) | SRPC shifts right/up — stagflation territory |
| SRAS shifts right (positive supply shock) | SRPC shifts left/down |
Demand events slide the point; supply events (and expectations) move the curve. If a question tells you inflation AND unemployment both rose — as in the 1970s oil shocks — no point on the original downward-sloping curve can produce that. The curve itself shifted right. That combination is stagflation.
A third shifter joins supply shocks: inflation expectations. When workers and firms come to expect higher inflation, they build it into wage demands and price setting — costs rise at every unemployment rate, and the SRPC shifts up. Falling expectations shift it down.
[GRAPH: SRPC — demand shock vs. supply shock
X-axis: Unemployment rate (%)
Y-axis: Inflation rate (%)
Panel 1: downward-sloping SRPC; point A at (5%, 2%); expansionary policy
slides the economy ALONG the curve to point B at (3.5%, 4%)
Panel 2: SRPC₁ shifts right/up to SRPC₂ after an oil-price spike;
point A at (5%, 2%) → point C at (7%, 5%) — both variables worse]
Suppose everyone got a 10% raise and every price rose 10% the same morning. Nobody is better off — nothing real changed. That thought experiment explains why the short-run tradeoff is powered by surprise, and why it dies once the surprise wears off.
The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment (NRU). In the long run there is no tradeoff: the economy can run 2% inflation or 10% inflation at the same natural unemployment rate. Inflation is a nominal choice; unemployment's resting point is set by real factors (frictional plus structural forces). This is the twin of the vertical LRAS — demand management cannot permanently change real variables.
The LRPC shifts only when the NRU itself changes — for example, better job-matching technology lowers frictional unemployment (LRPC left). No amount of money growth or stimulus moves it.
The stimulus cycle (the single most tested sequence in this topic). Start at full employment with 2% inflation:
On the LRPC, actual inflation equals expected inflation — nobody is being fooled. Holding unemployment below the NRU therefore requires inflation to keep accelerating past expectations; any constant, anticipated rate returns unemployment to the natural rate.
To break entrenched inflation, the central bank tightens: AD left → slide down-right along the current SRPC → unemployment rises above the NRU for a while. That temporary spell of above-natural unemployment — lost jobs and output per point of inflation removed — is the cost of disinflation. The early-1980s U.S. disinflation broke double-digit inflation at the price of a severe recession; homeowners who had locked in the era's 15%+ mortgage rates remember it well.
Credibility is the discount. The faster people believe the low-inflation commitment, the faster expectations (and the SRPC) fall, and the smaller the unemployment bill. Under adaptive expectations (people forecast from past inflation), adjustment is slow and the pain is the tuition. Under rational expectations (people use all available information, including announced policy), a fully credible plan can shift expectations quickly — and fully anticipated policy loses even its short-run punch. Only surprises move real variables.
Remember: disinflation is not deflation. Cutting inflation from 8% to 3% still means prices are rising — just more slowly.
M × V = P × Y
where M = money supply, V = velocity (times a dollar turns over per year), P = price level, Y = real output. If V and Y are stable, money growth passes directly into the price level: "too much money chasing too few goods." In growth-rate form: %ΔP ≈ %ΔM + %ΔV − %ΔY.
This is the same neutrality statement the vertical LRPC makes: sustained money growth ultimately buys inflation, not real output or lower unemployment. A central bank that grows money 8% per year while output grows 2% should expect roughly 6% inflation in the long run.
1. E. The SRPC plots inflation against unemployment, and in the short run they move inversely — lower unemployment comes with higher inflation. A confuses the Phillips curve's axes with AD-AS axes (and AS relationships are direct, not what the SRPC shows). B gets the variables right but the direction wrong — the short-run relationship is inverse. C describes aggregate demand's slope, a different graph. D confuses this with the Fisher relationship, which links interest rates to inflation, not unemployment.
Fix: Phillips curve = (unemployment, inflation) space, downward sloping in the short run; AD-AS = (output, price level) space.
2. D. More government spending shifts AD right: output up, unemployment down, inflation up — a slide up-left along the SRPC. A treats a demand event as a supply shock; only supply shocks and expectation changes shift the SRPC. B is the shift direction for a positive supply shock, and it is still a shift, not a slide. C is the movement for contractionary demand policy, the opposite direction. E gives demand policy power over the LRPC, which only moves when the natural rate changes.
Fix: Sort the event first — demand events slide the point along the curve; supply and expectations move the curve.
3. C. A cost-push shock (SRAS left) raises inflation at every unemployment rate: the SRPC shifts right/up. A and D treat a supply shock as a demand movement — but no AD change occurred. B is the direction for a positive supply shock, such as falling energy costs. E moves the long-run curve, which responds only to changes in the natural rate, not to input prices.
Fix: Mirror rule — SRAS left ↔ SRPC right; SRAS right ↔ SRPC left.
4. A. Unemployment and inflation both rose — a point northeast of the old curve, which a single downward-sloping SRPC cannot produce; the curve shifted right (negative supply shock or higher expected inflation). B is impossible: along one downward-sloping curve, the two variables trade off — they cannot both rise. C fails for the same reason: an AD increase lowers unemployment while raising inflation. D is the wrong shift direction — leftward means both variables improve. E invents a slope change; the LRPC stays vertical.
Fix: Two data points moving in the same direction = shifted curve; opposite directions = possible movement along.
5. B. In the long run, unemployment returns to its natural rate regardless of the inflation rate, so the LRPC stands vertical at the NRU. A grants the short-run tradeoff a permanence it does not have — that is what the vertical LRPC denies. C describes no standard curve; horizontal would mean one inflation rate at any unemployment. D confuses the expectations mechanism with the curve's shape — adaptive expectations affect the adjustment speed, not the long-run verticality. E puts the vertical line on the wrong axis value: it is fixed at the natural unemployment rate, and any fully expected inflation rate is consistent with it.
Fix: Vertical LRPC at the NRU = real variables are independent of nominal choices in the long run.
6. D. Higher expected inflation gets built into wages and prices, raising inflation at every unemployment rate — the SRPC shifts up. A is the effect of falling expectations. B misassigns the shifter: the LRPC moves only with the natural rate, never with expectations. C treats an expectations change as a demand movement — no slide occurs without an AD event. E misses that expectations are one of the SRPC's core shifters.
Fix: Expectations set the SRPC's height — expect more inflation, get a higher curve.
7. D. The full cycle: slide up-left (unemployment below NRU, inflation up), then expectations adjust and the SRPC shifts up, returning unemployment to the natural rate with inflation permanently higher. A describes only the short-run stop, before expectations adjust. B is impossible even short-run — stimulus that lowers unemployment raises inflation. C describes disinflation, the opposite policy. E assumes inflation falls back on its own; the ratchet leaves it at the new higher rate.
Fix: Stimulus at full employment = temporary real gain, permanent nominal cost.
8. A. P = MV/Y = (3 × 4)/6 = 12/6 = 2.0. B inverts the ratio (6/12). C computes VY/M = 24/3, mixing up which variables multiply. D stops at MV = 12 and forgets to divide by output. E slips to 6/4, dividing the wrong pair.
Fix: Write P = MV/Y before plugging in numbers — money times velocity, divided by real output.
9. C. With V stable, %ΔP ≈ %ΔM − %ΔY = 8 − 2 = 6 percent inflation per year. A gives money growth power over real output, which the long-run framework denies. B assumes velocity conveniently absorbs the money growth — the premise says it is stable. D contradicts the vertical LRPC: sustained, anticipated money growth cannot hold unemployment below natural. E has money growth leaving prices untouched, the reverse of the theory's prediction.
Fix: In the long run, money growth in excess of output growth becomes inflation, point for point.
10. B. Tightening slides the economy down-right along the SRPC: unemployment temporarily above the natural rate until expectations fall and the curve shifts down. A reverses the direction — contraction cools the labor market, it does not tighten it. C is backwards: disinflation eventually shifts the SRPC down, not right. D confuses a demand-side recession with capacity destruction; potential output survives. E confuses disinflation with deflation — 3 percent inflation still means rising prices.
Fix: The short-run price of lower inflation is a spell of above-natural unemployment; disinflation ≠ deflation.
11. C. Unemployment stays below the NRU only while actual inflation outruns expectations; a constant 5 percent gets anticipated, the SRPC shifts up, and unemployment returns to 5 percent. Holding it at 3 percent would require accelerating inflation. A extends the short-run curve to horizons where it no longer holds. B misdiagnoses the problem — coordination does not prevent expectations from adjusting. D invents a deflation requirement that exists nowhere in the model. E lets policy wishes move the natural rate, which is set by structural and frictional forces.
Fix: Below-natural unemployment is rented with inflation surprises; constant rates stop surprising.
12. E. Credibility speeds the fall in expected inflation, shifting the SRPC down faster and shrinking the above-natural unemployment spell. A inverts the mechanism — credibility speeds, not slows, adjustment. B ignores expectations entirely; the sacrifice depends on how fast they fall, not just the inflation gap. C is backwards: an unbelieved plan means expectations stay high and the cost is larger, not zero. D confuses credibility with the natural rate — the LRPC moves only with structural and frictional fundamentals.
Fix: The disinflation bill is proportional to the stubbornness of expectations; credibility is the discount.
1. E. The SRPC plots inflation against unemployment, and in the short run they move inversely — lower unemployment comes with higher inflation. A confuses the Phillips curve's axes with AD-AS axes (and AS relationships are direct, not what the SRPC shows). B gets the variables right but the direction wrong — the short-run relationship is inverse. C describes aggregate demand's slope, a different graph. D confuses this with the Fisher relationship, which links interest rates to inflation, not unemployment. Fix: Phillips curve = (unemployment, inflation) space, downward sloping in the short run; AD-AS = (output, price level) space.
2. D. More government spending shifts AD right: output up, unemployment down, inflation up — a slide up-left along the SRPC. A treats a demand event as a supply shock; only supply shocks and expectation changes shift the SRPC. B is the shift direction for a positive supply shock, and it is still a shift, not a slide. C is the movement for contractionary demand policy, the opposite direction. E gives demand policy power over the LRPC, which only moves when the natural rate changes. Fix: Sort the event first — demand events slide the point along the curve; supply and expectations move the curve.
3. C. A cost-push shock (SRAS left) raises inflation at every unemployment rate: the SRPC shifts right/up. A and D treat a supply shock as a demand movement — but no AD change occurred. B is the direction for a positive supply shock, such as falling energy costs. E moves the long-run curve, which responds only to changes in the natural rate, not to input prices. Fix: Mirror rule — SRAS left ↔ SRPC right; SRAS right ↔ SRPC left.
4. A. Unemployment and inflation both rose — a point northeast of the old curve, which a single downward-sloping SRPC cannot produce; the curve shifted right (negative supply shock or higher expected inflation). B is impossible: along one downward-sloping curve, the two variables trade off — they cannot both rise. C fails for the same reason: an AD increase lowers unemployment while raising inflation. D is the wrong shift direction — leftward means both variables improve. E invents a slope change; the LRPC stays vertical. Fix: Two data points moving in the same direction = shifted curve; opposite directions = possible movement along.
5. B. In the long run, unemployment returns to its natural rate regardless of the inflation rate, so the LRPC stands vertical at the NRU. A grants the short-run tradeoff a permanence it does not have — that is what the vertical LRPC denies. C describes no standard curve; horizontal would mean one inflation rate at any unemployment. D confuses the expectations mechanism with the curve's shape — adaptive expectations affect the adjustment speed, not the long-run verticality. E puts the vertical line on the wrong axis value: it is fixed at the natural unemployment rate, and any fully expected inflation rate is consistent with it. Fix: Vertical LRPC at the NRU = real variables are independent of nominal choices in the long run.
6. D. Higher expected inflation gets built into wages and prices, raising inflation at every unemployment rate — the SRPC shifts up. A is the effect of falling expectations. B misassigns the shifter: the LRPC moves only with the natural rate, never with expectations. C treats an expectations change as a demand movement — no slide occurs without an AD event. E misses that expectations are one of the SRPC's core shifters. Fix: Expectations set the SRPC's height — expect more inflation, get a higher curve.
7. D. The full cycle: slide up-left (unemployment below NRU, inflation up), then expectations adjust and the SRPC shifts up, returning unemployment to the natural rate with inflation permanently higher. A describes only the short-run stop, before expectations adjust. B is impossible even short-run — stimulus that lowers unemployment raises inflation. C describes disinflation, the opposite policy. E assumes inflation falls back on its own; the ratchet leaves it at the new higher rate. Fix: Stimulus at full employment = temporary real gain, permanent nominal cost.
8. A. P = MV/Y = (3 × 4)/6 = 12/6 = 2.0. B inverts the ratio (6/12). C computes VY/M = 24/3, mixing up which variables multiply. D stops at MV = 12 and forgets to divide by output. E slips to 6/4, dividing the wrong pair. Fix: Write P = MV/Y before plugging in numbers — money times velocity, divided by real output.
9. C. With V stable, %ΔP ≈ %ΔM − %ΔY = 8 − 2 = 6 percent inflation per year. A gives money growth power over real output, which the long-run framework denies. B assumes velocity conveniently absorbs the money growth — the premise says it is stable. D contradicts the vertical LRPC: sustained, anticipated money growth cannot hold unemployment below natural. E has money growth leaving prices untouched, the reverse of the theory's prediction. Fix: In the long run, money growth in excess of output growth becomes inflation, point for point.
10. B. Tightening slides the economy down-right along the SRPC: unemployment temporarily above the natural rate until expectations fall and the curve shifts down. A reverses the direction — contraction cools the labor market, it does not tighten it. C is backwards: disinflation eventually shifts the SRPC down, not right. D confuses a demand-side recession with capacity destruction; potential output survives. E confuses disinflation with deflation — 3 percent inflation still means rising prices. Fix: The short-run price of lower inflation is a spell of above-natural unemployment; disinflation ≠ deflation.
11. C. Unemployment stays below the NRU only while actual inflation outruns expectations; a constant 5 percent gets anticipated, the SRPC shifts up, and unemployment returns to 5 percent. Holding it at 3 percent would require accelerating inflation. A extends the short-run curve to horizons where it no longer holds. B misdiagnoses the problem — coordination does not prevent expectations from adjusting. D invents a deflation requirement that exists nowhere in the model. E lets policy wishes move the natural rate, which is set by structural and frictional forces. Fix: Below-natural unemployment is rented with inflation surprises; constant rates stop surprising.
12. E. Credibility speeds the fall in expected inflation, shifting the SRPC down faster and shrinking the above-natural unemployment spell. A inverts the mechanism — credibility speeds, not slows, adjustment. B ignores expectations entirely; the sacrifice depends on how fast they fall, not just the inflation gap. C is backwards: an unbelieved plan means expectations stay high and the cost is larger, not zero. D confuses credibility with the natural rate — the LRPC moves only with structural and frictional fundamentals. Fix: The disinflation bill is proportional to the stubbornness of expectations; credibility is the discount.