Short-run and long-run aggregate supply, the Keynesian and Neo-Classical views, and the short-run and long-run Phillips Curve.

What this dot point is asking

WJEC wants you to explain short-run and long-run aggregate supply and the Keynesian and Neo-Classical views, and to use the short-run and long-run Phillips Curve and the role of expectations to analyse the inflation-unemployment relationship.

The answer

Aggregate supply: the two views

The shape of LRAS determines whether demand management can raise real output lastingly. On the Neo-Classical vertical LRAS, a rise in aggregate demand raises only the price level in the long run, because output is fixed at full capacity, so the focus should be supply-side reform. On the Keynesian L-shaped curve, demand management can raise real output and employment when there is spare capacity, becoming inflationary only near full capacity. This disagreement carries straight over into the Phillips Curve, which is the inflation-unemployment counterpart of the AS debate.

The short-run Phillips Curve

The original Phillips relationship suggested governments could "choose" a point on the curve, accepting higher inflation for lower unemployment or vice versa, which underpinned demand management in the post-war decades. The mechanism is that as unemployment falls and the labour market tightens, workers can bargain for higher wages, raising costs and prices. For a time this seemed a stable, exploitable trade-off, and it fitted the upward-sloping SRAS: boosting demand raised output and employment but also prices.

The long-run Phillips Curve and expectations

The expectations-augmented Phillips Curve, developed after stagflation (high inflation and high unemployment together) broke the simple trade-off, explains why the long-run curve is vertical. If the government boosts demand to push unemployment below the natural rate, inflation rises; but workers come to expect that inflation and demand higher money wages to protect their real wages, which shifts the short-run Phillips Curve up. Unemployment returns to the natural rate, now at a higher inflation rate. So demand management can move along the short-run curve temporarily but cannot lower unemployment below the natural rate permanently. Reducing unemployment lastingly requires supply-side policy to lower the natural rate itself.

Examples in context

Example 1. 1970s stagflation. The 1970s, when many economies suffered high inflation and high unemployment simultaneously, destroyed faith in a stable inflation-unemployment trade-off. Driven partly by oil-price shocks (a leftward SRAS shift) and partly by rising inflation expectations, stagflation could not be explained by the simple Phillips Curve and led directly to the expectations-augmented version and the vertical long-run curve. It is the historical evidence the exam expects you to cite.

Example 2. Independent central banks and anchored expectations. The modern emphasis on an independent central bank with a credible inflation target (the UK's 2 per cent) is a direct response to the expectations story: if the public believes inflation will stay at target, inflation expectations are "anchored", which keeps the short-run Phillips Curve stable and makes it cheaper to keep both inflation and unemployment low. This shows the expectations-augmented Phillips Curve shaping real institutional design.

Try this

Q1. State what the short-run Phillips Curve shows. [2 marks]

• Cue. An inverse relationship (trade-off) between the rate of inflation and the rate of unemployment: lower unemployment is associated with higher inflation.

Q2. Explain why the long-run Phillips Curve is vertical. [3 marks]

• Cue. Attempts to hold unemployment below the natural rate raise inflation, but as inflation expectations adjust the short-run curve shifts up and unemployment returns to the natural rate, so there is no permanent trade-off.