1. There is a short-run tradeoff between the rate of inflation and the rate of unemployment.
2. Aggregate Supply shocks cause both the rate of inflation and rate of unemployment to increase.
3. There is no significant tradeoff between the rate of inflation and rate of unemployment in the long-run; therefore, in the LR, Phillips Curve is always vertical.

• Demonstrates the inverse relationship between unemployment rates and inflation rates
  
• Assuming a constant short-run AS curve:
  • Inflation rate ↑ → Unepmloyment ↓ (when AD increases, there is a upward pressure on prices and UE therefore decreases)
  • Inflation rate ↓ → Unemployment ↑ (when AD decreases, there is a downward pressure on prices and UE therefore increases)
  • Thus, the relationship is inverse as shown by the graph below:
  
  

• Stagflation: when inflation and unemployment rise simultaneously, resulting in an increase in input cost (The Phillips Curve shifts outward)
• Adverse Aggregate Supply Shocks: Sudden large increases in resource costs (known as supply shock) push short-run aggregate supply (the PC curve)leftward (such as OPEC in the '70s and '80s)
  • These shocks distort the usual inflation-unemployment relationship: a leftward shift of the short-run aggregate supply pc curve increases price level and increases the unemployment rate (cost-push inflation)
  
  
  
• Stagflation's Demise:
  • However, in the long term:
    • Due to great unemployment, workers accept lower wages, and firms' costs decrease
    • Foreign competition also holds down wages and price hikes
    • Input prices is a determinant of AS, therefore when input prices (wages) decrease, AS will shift to the right
    • OPEC etc. loses monopoly power
    • A component of laissez-faire economics is the theory that the economy will self-correct. However, the economy will suffer great unemployment in the process.
    When AD shifts to the right, inflation occurs and real output increases, thus, it shifts left ALONG the Phillips curve. (increase in inflation but decrease in UE rate) However, when AS shifts to the left due to decrease in productivity, and increase is input prices, the Phillips curve shift rightwards restoring to the natural rate of unemployment. Thus, the Phillips curve's long run is always vertical.