Phillips Curves! SRPC and LRPC

An economist named Alban Phillips studied the interaction between inflation and unemployment in the mid-20th century and derived the so-called "Phillips curve".  In the short-run, Phillips and his successors argued there was an inverse relationship between the inflation rate and the unemployment rate: as inflation goes up, unemployment goes down, and vice versa.  They made this claim because since wages are so critical to all firms as costs of factors of production, if there are fewer and fewer unemployed people, wage levels (and thus the overall price level) would increase as firms have to pay more for scarcer labor.  This graph shows the short-run Phillips curve (SRPC):

But then, the 1970s occurred.  In this decade, we observed stagflation, or high inflation AND high unemployment.  This caused the SRPC model to fall out of favor and led to a new theory of this relationship by a group of monetarists led by Milton Friedman.  They argued there was no link between inflation and unemployment and, following the analysis of neo-Classical LRAS, said there would be a short-run fixed "natural" level of unemployment that would differ between countries.  In fact, they maintain that if the government intervened to reduce unemployment, the only result would be a higher and higher inflation rate at the same original level of unemployment.  Let's look at the graph:

We can see above that the initial equilibrium is an inflation rate of 2% and an unemployment rate of 4%.  At this level, people expect 2% inflation.  Monetarists would argue that if the government used demand-side policies to reduce unemployment (more demand for g/s means more workers are needed), the the short-run.  As this occurs, the inflation rate increases to 5%, and unemployment will fall to 3% (lower red arrow).  However, people will realize that although the number on their paycheck has increased (nominal figure), the real rate adjusted for inflation did not change, and anger rises.  Some people thus leave their jobs and unemployment returns to 4% (lower blue arrow).  If the government again tries to cut unemployment through expansionary fiscal or monetary policy, the rate will again fall to 3% and workers will again negotiate higher wages.  Here we would be at an inflation rate of 9% with 3% unemployment.  Yet, again the works will realize that their real income hasn't changed and unemployment will again rise to 4%.  This is how the long-run Phillips cuve (LRPC) is derived, and this term is also called natural rate of unemployment (NRU).  We can define the NRU as the rate of employment that occurs when at the full employment level of output (Yfe) and the labor market is in equilibrium.

One more graph.  How can we lower the unemployment rate if we follow neo-Classical theory.  Answer - shift the LRPC in!  Monetarists would argue that a country can decrease it's NRU through achieving economic growth (see neo-Classical LRAS post) which would cause a leftward shift in LRPC.  To do this, they encourage implementing market-oriented policies like reducng taxes and deregulating.