Phillips curve - Wikipedia
By contrast, a neoclassical long-run aggregate supply curve will imply a As a result, the long-run Phillips curve relationship, shown in Figure (b), is a. The Phillips curve suggests there is a trade-off between inflation and Curve is based on the findings of A.W. Phillips in The Relationship. The Keynesian theory implied that during a recession inflationary pressures are A Keynesian Phillips Curve Tradeoff between Unemployment and Inflation. This chart shows the negative relationship between unemployment and inflation.
But there are certain variables which cause the Phillips curve to shift over time and the most important of them is the expected rate of inflation.
So long as there is discrepancy between the expected rate and the actual rate of inflation, the downward sloping Phillips curve will be found. But when this discrepancy is removed over the long run, the Phillips curve becomes vertical. In order to explain this, Friedman introduces the concept of the natural rate of unemployment.
Trade off between unemployment and inflation | Economics Help
In represents the rate of unemployment at which the economy normally settles because of its structural imperfections. It is the unemployment rate below which the inflation rate increases, and above which the inflation rate decreases. At this rate, there is neither a tendency for the inflation rate to increase or decrease. Thus the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation.
It is thus an equilibrium rate of unemployment toward which the economy moves in the long run. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment.
This natural or equilibrium unemployment rate is not fixed for all times. Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy.
These may be minimum wage laws, inadequate employment information, deficiencies in manpower training, costs of labour mobility, and other market imperfections.
But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctly forecasts inflation and can adjust wages to the forecast. Suppose the economy is experiencing a mild rate of inflation of 2 per cent and a natural rate of unemployment N of 3 per cent. At point A on the short-run. Now assume that the government adopts a monetary-fiscal programme to raise aggregate demand in order to lower unemployment from 3 to 2 per cent.
Trade-Off between Inflation and Unemployment: The Phillips Curve
The increase in aggregate demand will raise the rate of inflation to 4 per cent consistent with the unemployment rate of 2 per cent. When the actual inflation rate 4 per cent is greater than the expected inflation rate 2 per centthe economy moves from point A to B along the SPC1 curve and the unemployment rate temporarily falls to 2 per cent.
This is achieved because the labour has been deceived. It expected the inflation rate of 2 per cent and based their wage demands on this rate. But the workers eventually begin to realise that the actual rate of inflation is 4 per cent which now becomes their expected rate of inflation. Now workers demand increase in money wages to meet the higher expected rate of inflation of 4 per cent.
They demand higher wages because they consider the present money wages to be inadequate in real terms. In other words, they want to keep up with higher prices and to eliminate fall in real wages. If the government is determined to maintain the level of unemployment at 2 per cent, it can do so only at the cost of higher rates of inflation.
From point C, unemployment once again can be reduced to 2 per cent via increase in aggregate demand along the SPC2 curve until we arrive at point D. With 2 per cent unemployment and 6 per cent inflation at point D, the expected rate of inflation for workers is 4 per cent.
As soon as they adjust their expectations to the new situation of 6 per cent inflation, the short-run Phillips curve shifts up again to SPC3, and the unemployment will rise back to its natural level of 3 per cent at point E. On this curve, there is no trade-off between unemployment and inflation. Rather, any one of several rates of inflation at points A, C and E is compatible with the natural unemployment rate of 3 per cent. Any reduction in unemployment rate below its natural rate will be associated with an accelerating and ultimately explosive inflation.
But this is only possible temporarily so long as workers overestimate or underestimate the inflation rate. In the long-run, the economy is bound to establish at the natural unemployment rate.
There is, therefore, no trade-off between unemployment and inflation except in the short run. This is because inflationary expectations are revised according to what has happened to inflation in the past. So when the actual rate of inflation, say, rises to 4 per cent in Figure 11, workers continue to expect 2 per cent inflation for a while and only in the long run they revise their expectations upward to 4 per cent. Since they adapt themselves to the expectations, it is called the adaptive exceptions hypothesis.
According to this hypothesis, the expected rate of inflation always lags behind the actual rate. But if the actual rate remains constant, the expected rate would ultimately become equal to it. This leads to the conclusion that a short-run trade off exists between unemployment and inflation, but there is no long run trade-off between the two unless a continuously rising inflation rate is tolerated. The accelerationist hypothesis of Friedman has been criticised on the following grounds: The vertical long-run Phillips curve relates to steady rate of inflation.
But this is not a correct view because the economy is always passing through a series of disequilibrium positions with little tendency to approach a steady state. In such a situation, expectations may be disappointed year after year. Friedman does not give a new theory of how expectations are formed that would be free from theoretical and statistical bias. This makes his position unclear.
The vertical long-run Phillips curve implies that all expectations are satisfied and that people correctly anticipate the future inflation rates. Critics point out that people do not anticipate inflation rates correctly, particularly when some prices are almost certain to rise faster than others.
There are bound to be disequilibria between supply and demand caused by uncertainty about the future and that is bound to increase the rate of unemployment. Far from curing unemployment, a dose of inflation is likely to make it worse. In one of his writings Friedman himself accepts the possibility that the long-run Phillips curve might not just be vertical, but could be positively sloped with increasing doses of inflation leading to increasing unemployment.
Some economists have argued that wage rates have not increased at a high rate of unemployment.
It is believed that workers have a money illusion. They are more concerned with the increase in their money wage rates than real wage rates.
Some economists regard the natural rate of unemployment as a mere abstraction because Friedman has not tried to define it in concrete terms. Saul Hyman has estimated that the long-run Phillips curve is not vertical but is negatively sloped.
Trade-Off between Inflation and Unemployment: The Phillips Curve
However, with the increase in real GDP, firms take on more workers leading to a decline in unemployment a fall in demand deficient unemployment Thus with faster economic growth in the short-term, we experience higher inflation and lower unemployment. Increase in AD causing inflation This Keynesian view of the AS curve suggests there can be a trade off between inflation and demand deficient unemployment.
This rise in real output creates jobs and a fall in unemployment. However, the rise in AD also causes a rise in the price level from P1 to P2.
Unemployment has fallen, but a trade-off of higher inflation. If an economy experienced inflation, then the Central Bank could raise interest rates.
Higher interest rates will reduce consumer spending and investment leading to lower aggregate demand. This fall in aggregate demand will lead to lower inflation. However, if there is a decline in Real GDP, firms will employ fewer workers leading to a rise in unemployment.
Empirical evidence behind trade-off The Phillips Curve is based on the findings of A. There are occasions when you can see a trade-off. In the late s, inflation falls from 6. This suggests there can be a trade-off between unemployment and inflation. However, equally you can look at other periods, and the trade-off is harder to see.
Monetarist View The Phillips curve is criticised by the Monetarist view. Monetarists argue that increasing aggregate demand will only cause a temporary fall in unemployment. Monetarist Phillips Curve Diagram Rational expectation monetarists believe there is no trade-off even in the short-term.