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The phillips curve on inflation and unemployment

Philips Curve and Rational Expectations Theory! In the simple Keynesian model of an economy, the aggregate supply curve with variable price level is of inverse L-shape, that is, it is a horizontal straight line up to the full-employment level of output and beyond that it becomes horizontal.

This means that during recession or depression when the economy is having a good deal of excess capacity and large-scale unemployment of labour and idle capital stock, the aggregate supply curve is perfectly elastic. When full-employment level of output is reached, aggregate supply curve becomes perfectly inelastic.

With this shape of aggregate supply curve assumed in the simple Keynesian model, increase in aggregate demand before the level of full employment causes increase in the level of real national output and employment with price level remaining unchanged.

That is, no cost has to be incurred in the form of rise in the price level i. In the Keynesian model, once the full-employment level of output is reached and aggregate supply curve becomes vertical, further increase in aggregate demand caused by the expansionary fiscal and monetary policies will only raise the price level in the economy.

Phillips Curve

That is, in this simple Keynesian model, inflation occurs in the economy only after full-employment level of output has been attained. Thus, in the simple Keynesian model with inverse L-shaped aggregate supply curve there is no trade-off or clash between inflation and unemployment. However, the actual empirical evidence did not fit well in the above simple Keynesian macro model.

A noted British economist, A. Phillips, published an article in 1958 based on his good deal of research using historical data from the U. This inverse relation implies a trade-off, that is, for reducing unemployment, price in the form of a higher rate of inflation has to be paid, and for reducing the rate of inflation, price in terms of a higher rate of unemployment has to be borne.

On graphically fitting a curve to the historical data Phillips obtained a downward sloping curve exhibiting the inverse relation between rate of inflation and the rate of unemployment and this curve is now named after his name as Phillips Curve.

This Phillips curve is shown in Fig. It will be seen that when rate of inflation is 10 per cent, the unemployment rate is 3 per cent, and when rate of inflation is reduced to 5 per cent per annum, say by pursuing contractionary fiscal policy and thereby reducing aggregate demand, the rate of unemployment increases to 8 per cent of labour force.

  • In the short run, when the actual rate of unemployment is higher than the natural rate of unemployment i;
  • Since monetary and fiscal policies can shift the aggregate demand curve and affect the level of inflation and unemployment rate on the Phillips curve, such policies can be used by the policymakers to choose the desired combination of unemployment and inflation;
  • He challenged the concept of a stable downward- sloping Phillips curve;
  • As a result, profits of business firms will increase and they will expand output and employment causing the reduction in rate of unemployment and rise in the inflation rate.

The actual Phillips curve drawn from the data of sixties 1961 -69 for the United States also shows the inverse relation between unemployment rate and rate of inflation see Fig.

Such empirical data the phillips curve on inflation and unemployment to the fifties and sixties for other developed countries seemed to confirm the Phillips curve concept. On the basis of this, many economists came to believe that there existed a stable Phillips curve which depicted a predictable inverse relation between inflation and unemployment.

Further, on the basis of a stable Phillips curve for a country, they emphasized the trade-off that confronts the economic policy makers.

This trade-off presents a dilemma for the policy makers; should they choose a higher rate of inflation with lower unemployment or a higher rate of unemployment with a low inflation rate? In what follows we first explain the rationale underlying the Phillips curve, that is, how the inverse relationship between inflation and unemployment can be theoretically explained.

We will further explain why this concept of stable Phillips curve depicting inverse relation between inflation and unemployment broke down during seventies and early eighties. During seventies a strange phenomenon was witnessed in the USA and Britain when there existed a high rate of inflation side by side with high unemployment rate.

This was contrary to both Phillips curve concept and the simple Keynesian model. This simultaneous existence of both high rate of inflation and high unemployment rate or low level of real national product during the seventies and early eighties has been described as stagflation.

Explanation of Phillips Curve: Let us first provide an explanation for the Phillips curve. Both Keynesians and Monetarists agreed to the existence of the Phillips curve. The explanation of Phillips curve by the Keynesian economists is quite simple and is graphically illustrated in Fig. It may be noted that Keynesian economists assume the upward-sloping aggregate supply curve.

Phillips Curve

In fact, Keynes himself recognized that the curve AS is upward sloping in intermediate range, that is, as the economy approaches near-full employment level, the aggregate supply curve slopes upward.

According to Keynesian economists, the phillips curve on inflation and unemployment supply curve is upward sloping for two reasons. First, as output is increased by the firms in the economy, diminishing returns to variable factors, especially to labour, occur or accrue resulting in fall in marginal physical product MPPL of labour. The second reason for the marginal cost to go up is the rise in the wage rate as employment and output are increased. When under pressure of aggregate demand for output, demand for labour increases, its wage rate tend to rise, supply curve of labour being upward sloping.

Even Keynes himself believed that as the economy approached near-full employment, labour shortage might appear in some sectors of the economy causing increase in the wage rate. Thus, marginal cost of firms increases as more labour is employed due to diminishing marginal physical product of labour and also because wage rate also rises.

In fact Phillips himself, while discussing the relationship between inflation and unemployment, considered the relationship between rate of increase in wage rate as a proxy for the rate of inflation on the one hand and unemployment rate on the other. Now, it will be seen from panel a of Fig. Now, suppose the aggregate demand curve increases from AD0 to AD1, it will be seen that price level rises to P1 and aggregate national output increases from Y0 to Y1.

Note that increase in aggregate national product means increase in employment of labour and therefore reduction in unemployment rate.

Inflation and Unemployment: Philips Curve and Rational Expectations Theory

Thus the rise in the price level from P0 to P1 i. Further, if aggregate demand increases to AD2, the price level further rises to P2 and national output increases to Y2 which will further lower the rate of unemployment.

The greater the rate at which aggregate demand increases, the higher will be the rate of inflation which will cause greater increase in aggregate output and employment resulting in much lower rate of unemployment. Thus, a higher rate of increase in aggregate demand and consequently a higher rate of rise in price level is associated with the lower rate of unemployment and vice versa.

This is what is represented by Phillips curve. Consider panel b of Fig. In panel b of the Fig. When the aggregate demand shifts to AD1, there is a certain rate of inflation and price level rises to P1 and aggregate output expands to Y1.

  • In short run, policy makers are able to achieve lower unemployment at the cost of the higher actual inflation rate;
  • Now, if a decline in aggregate demand occurs, say as a result of contraction of money supply by the Central Bank of a country, this will reduce inflation rate below the 9 per cent expected rate.

As seen above, this increase in aggregate output leads to the increase in employment of labour bringing about decline in unemployment rate. Suppose the rate of rise in the price level i. This gives us a downward-sloping Phillips curve PC.

It is clear from above that through increase in aggregate demand and upward-sloping aggregate supply curve; Keynesians were able to explain the downward-sloping Phillips curve showing the negative relation between rates of inflation and unemployment.

The Phillips curve

Collapse of Phillips Curve 1971-91: During the sixties Phillips curve became an important concept of macroeconomic analysis. The stable relationship described by it suggested that policy makers could have a lower rate of unemployment if they could bear with a higher rate of inflation. On the contrary, they could achieve a low rate of inflation only if they were prepared to reconcile with a higher rate of unemployment.

But a stable Phillips curve could not hold good during the o seventies and eighties, especially in the United States. Therefore, experience in the two decades 1971 -91 has prompted some economists to say that the stable Phillips curve has disappeared.

In these two decades we have periods when rates of both inflation and unemployment increased that is, a high rate of inflation was associated with a high unemployment rate, which shows the absence of trade-off. We have shown the data of inflation rate and unemployment in case of the United States in Fig. From the data it appears that instead of remaining stable, the Phillips curve shifted to the right in the seventies and early eighties and to the left during the late eighties, see Fig.

Causes of Shift in Phillips Curve: Now, what could be the cause of shift in the Phillips curve? There are two explanations for this. First, according to Keynesians, the occurrence of higher inflation rate along with the increase in unemployment rate witnessed during the seventies and early eighties was due to the adverse supply shocks in the form of fourfold increase in the prices of oil and petroleum products delivered to the American economy first in 1973-74 and then again in 1979-80.

The hike in price of oil by OPEC, the cartel of oil producing Middle East countries brought about a rise in the cost of production of several commodities for the production of which oil was used as an energy input. Further, the oil price hike also raised the transportation costs of all commodities. The increase in cost of production and transportation of commodities caused a shift in the aggregate supply curve upward to the left. This is generally described as adverse supply shock which raised the unit cost at each level of output.

It will be seen from Fig. At the new equilibrium point H, price level has risen to P1 and output has fallen to OY1 which will cause unemployment rate to rise. Thus, we have a higher price level with a higher unemployment rate. This explains the rise in the price level with the rise in the unemployment rate, the phenomenon which was witnessed during the seventies and early eighties in the developed capitalist countries the phillips curve on inflation and unemployment as the U. Note that this has been interpreted by some economists as a shift in the Phillips curve and some as demise or collapse of the Phillips curve.

Natural Rate Hypothesis and Adaptive Expectations: A second explanation of occurrence of a higher rate of inflation simultaneously with a higher rate of unemployment was provided by Friedman.

He challenged the concept of a stable downward- sloping Phillips curve. According to him, though there is a trade-off between rate of inflation and unemployment in the short run, that is, there exists a short-run downward sloping Phillips curve, but it is not stable and it often shifts both leftward and rightward. He argued that there is no long-run stable trade-off between rates of inflation and unemployment. His view is that the economy is stable in the long run at the natural rate of unemployment and therefore the long-run Phillips curve is a vertical straight line.

He argues that misguided Keynesian expansionary fiscal and monetary policies based on the wrong assumption that a stable Phillips curve exists only result in increasing rate of inflation.

Natural Rate of Unemployment: It is necessary to the phillips curve on inflation and unemployment the concept of natural rate of unemployment on which the concept of long-run Phillips curve is based. The natural rate of unemployment is the rate at which in the labour market the current number of unemployed is equal to the number of jobs available. These unemployed workers are unemployed for the frictional and structural reasons, though the equivalent number of jobs is available for them.

For instance, the fresh entrants may spend a good deal of time in searching for the jobs before they are able to find work. Further, some industries may be registering a decline in their production rendering some workers unemployed, while others may be growing creating new jobs for workers.

But the unemployed workers may have to be provided new training and skills before they are deployed in the newly created jobs in the growing industries.

Since the equivalent number of jobs is available for them, full employment is said to prevail even in the presence of this natural rate of unemployment. It is presently believed that 4 to 5 per cent rate of unemployment represents a natural rate of unemployment in the developed countries. Friedman put forward a theory of adaptive expectations according to which people from their expectations on the basis of previous and present rate of inflation, and change or adapt their expectations only when the actual inflation turns out to be different from their expected rate.

The view of Friedman and his follower monetarists is illustrated in Figure 21. To begin with SPC1 is the short-run Phillips curve and the economy is at point A0, on it corresponding to the natural rate of unemployment equal to 5 per cent of labour force. The location of this point A0 on the short-run Phillips curve depends on the level of aggregate demand. The other assumption we make is that nominal wages have been set on the expectations that 5 per cent rate of inflation will continue in the future.

Now, suppose for some reasons the government adopts expansionary fiscal and monetary policies to raise aggregate demand. The consequent increase in aggregate demand will cause the rate of inflation to rise, say to seven per cent.

  • It may be noted that Keynesian economists assume the upward-sloping aggregate supply curve;
  • This reduction in their profit implies that the original motivation that prompted them to expand output and increase employment resulting in lower unemployment rate will no longer be there;
  • Lucas , Milton Friedman , and F;
  • Lucas , Milton Friedman , and F;
  • The United States never experienced stagflation until the 1970s, when rising unemployment did not coincide with declining inflation;
  • However, the actual empirical evidence did not fit well in the above simple Keynesian macro model.