The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run, there is no trade-off. In the 1960's, economists believed that the short-run Phillips curve was stable. By the 1970's, economic events dashed the idea of a predictable Phillips curve. What could have happened in the 1970's to ruin an entire theory? Stagflation caused by a aggregate supply shock.
Stagflation and Aggregate Supply Shocks
Stagflation is a combination of the words "stagnant" and "inflation," which are the characteristics of an economy experiencing stagflation: stagnating economic growth and high unemployment with simultaneously high inflation. The stagflation of the 1970's was caused by a series of aggregate supply shocks. In this case, huge increases in oil prices by the Organization of Petroleum Exporting Countries (OPEC) created a severe negative supply shock. The increased oil prices represented greatly increased resource prices for other goods, which decreased aggregate supply and shifted the curve to the left . As aggregate supply decreased, real GDP output decreased, which increased unemployment, and price level increased; in other words, the shift in aggregate supply created cost-push inflation.
Aggregate Supply Shock
In this example of a negative supply shock, aggregate supply decreases and shifts to the left. The resulting decrease in output and increase in inflation can cause the situation known as stagflation.
Shifting the Phillips Curve
The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment and high inflation. At the time, the dominant school of economic thought believed inflation and unemployment to be mutually exclusive; it was not possible to have high levels of both within an economy. Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there were now corresponding levels of inflation that were higher than the Phillips curve predicted; the Phillips curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable trade-off between unemployment and inflation.