The chart above demonstrates the Phillips curve, if we assume that the economy unemployment level is at point 0 and that the inflation level is at point x then if inflation increases to point A then the level of unemployment will reduce from point 0 to point 1. if inflation is at point x and inflation is reduced to point B then the level of unemployment will increase from point 0 to 2. Therefore the cost of reducing inflation is increased unemployment.
Inflation is the persistent rise in price in an economy over a long period of time, there are two forms of inflation which include cost push inflation and demand pull inflation. Demand pull inflation is as a result of increased demand that exceeds the supply level, when demand increases and supply remains constant then price of the good rises and this is what refered to as demand pull inflation.
Cost push inflation results from a number of interactions in the economy, this type of inflation is related to wage rates and the increased cost of production which results into an increase in price of goods. In an economy cost push inflation occurs where workers demand for higher wage rates, when wage rates are increased the cost of production increases. When the cost of production increases then the price of goods increase leading to inflation. When the price of goods increase consumers who are the workers experience a reduction in their real income and therefore demand for higher pay and the cycle continues, however there are other factors that may lead to inflation example increased money supply, increased government expenditure and reduced borrowing rates, inflation can therefore be reduced by reducing government expenditure, reducing money supply and increasing borrowing rates or interest rates.
Long run and the short run Phillips curve:
Due to rational expectations in the economy the short run and long run Phillips curve differ, the long run Phillips curve is drawn as a vertical line, this concept is due to the natural rate of unemployment that prevails in the economy, when individuals in the economy rational expectations that inflation will increase then the inflation level will be higher than the expected inflation level, diagram below shows the long run and the short run Phillips curve.
The chart above shows the long run and short run Phillips curves, if the economy starts at short run Phillips curve 1 and individuals in the economy have rational expectations that inflation will rise, then inflation will rise but the rational expectations will increase inflation to higher level at the same unemployment level and this will lead to a shift in the short run Phillips curve to short run Phillips curve 2, the point market b on the above diagram shows the non accelerated rate of unemploym