Phillips curve

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relation between inflation and wage rate

Text of Phillips curve

The Phillips Curve1958 Professor A.W. Phillips expressed a statistical relationship between the rate of growth of money wages and unemployment from 1861 1957. A curve that shows the relationship between the inflation rate and the unemployment rate when the natural unemployment rate and the expected inflation rate remain constant. Rate of growth of money wages linked to inflationary pressure. Led to a theory expressing a trade-off between inflation and unemployment. A fall in unemployment may lead to an acceleration in wage inflation as the labour market tightens. Falling unemployment implies that: -- labour demand is rising --the pool of surplus labour available to employers is diminishing. -- a rising number of unfilled job vacancies emergence of labour shortages in some industries(particularly skilled labours). --increase in bargaining power of workers --a risk that strength of labour demand will lead to rise in wage claims and basic pay settlements.

AW Phillips (1958) looked at the unemployment rate and wage inflation rate for the UK over a 96 year period and noticed that there was a stable , inverse and non-linear relationship between the two. This implied that an economy trade off a lower level of unemployment, say , for a higher level of inflation.

Rationale for the relationship: In short run, there was an aggregate supply constraint which meant that an increase in AD might lead to inflation.Reason for non-linearity: As unemployment falls, the threat of becoming unemployed falls so workers seek greater wage increase.

Wage growth % (Inflation)

The Phillips CurveAn inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation.

3.0%

1.5%

4%

6% PC2

PC1

Unemployment (%)

FREIDMANS CRITICISMS OF THE PHILLIPS CURVE Friedman in an address to the US economics association (1968) criticised the Phillips curve. Original Phillips relationship only held in short run In the long run there was no trade off between inflation and unemployment Position of the Phillips curve in the inflation , unemployment space was determined by peoples expectations of inflation. If the inflation rate was higher than the expected rate then the Phillips curve would shit upwards and vice versa. Thus the expectations augmented Phillips was born.

LONG-RUN ...The long-run Phillips curve is a vertical line at the natural unemployment rate.

In the long run, there is no unemploymentinflation tradeoff.

The Long-Run Phillips Curve The long-run Phillips curve [LRPC] is a vertical line that shows the relationship between inflation and unemployment when the economy is at full employment. It asserts that full employment is consistent with any inflation rate in the relevant range in the long run, the economy will tend to return to the natural rate [NAIRU] of its own accord. It is analogous to the potential GDP [or capacity] vertical straight line in the AS-AD diagram, which asserted full employment was consistent with any price level in the long run.

The Phillips Curve Where the long run Phillips Curve cuts the horizontal axis would be the rate of unemployment at which inflation was constant the so-called Non-Accelerating Inflation Rate of Unemployment (NAIRU)

The Phillips Curve To reduce unemployment to below the natural rate would necessitate:1. Influencing expectations persuading individuals that inflation was going to fall 2. Boosting the supply side of the economy increase capacity (pushing the PC curve outwards)

Aggregate Supply and the Short-Run Phillips Curve

The AS-AD model provides an analogy to the negative relationship between unemployment and inflation along the short-run Phillips curve. The short-run Phillips curve is another way of looking at what lies behind the upwardsloping aggregate supply curve, but switching from price-level to rate of inflation. Both curves arise because the money wage rate is sticky in the short run.

Inflation and Unemployment using AS/ADInflation AS2 AS1The short runAD economy has in inflation The rise in the leads to a fall an is only Assume fall in unemployment temporary; as AS but inflationary unemployment shifts, unemployment will rate of 2% and a level of national start incomeagain and unemployment rate pressures givinginflationeconomy will end to rise push an the up to 3.75%. upProducers try toin a positionreason.at inof 4%. ADrun expand output but the long rises for some with unemployment at employing higher increased cost 4% but with more inflation. Expansionary fiscalworkers more expensive capital, paying or monetary policy will only lead to reductions results in to do work etc. Increased cost in unemploymentto the left workersthe long a shift in AS in the short run. In start to run unemployment will return to its natural be laid off. rate. Attempts to reduce unemployment below the natural rate will be inflationary.

4.0% 3.75% 2%

AD2AD1U = 4% U = 3%

Real National Income

Unemployment and Real GDP At full employment, the quantity of real GDP is potential GDP and the unemployment rate is the natural unemployment rate also known as NAIRU, which stands for Non-Accelerating Inflation Rate of Unemployment. If real GDP exceeds potential GDP, employment exceeds its full-employment level and the unemployment rate falls below the natural unemployment rate. With unemployment below NAIRU, inflation speeds up accelerates -- because the labor market is tight. If unemployment is above NAIRU, inflation tends to slow down decelerate because of slackness in the labor market.

Why Bother with the Phillips Curve? First, it focuses directly on two key real-world policy targets: the inflation rate and the unemployment rate. Second, the aggregate supply curve shifts whenever the money wage rate or potential GDP changes, and this suggests not-very-realistic changes in output and price level. More realistically, we argue that the short-run Phillips curve does not shift unless either the natural unemployment rate [NAIRU] or the expected inflation rate changes.

Changes in the Natural Unemployment RateIf the natural unemployment rate, the NAIRU, changes, both the long-run Phillips curve and the short-run Phillips curve shift. When the natural unemployment rate increases, both the long-run Phillips curve and the short-run Phillips curve shift rightward. When the natural unemployment rate decreases, both the long-run Phillips curve and the short-run Phillips curve shift leftward.

SHORT-RUN AND LONG-RUN ...Figure shows the effect of changes in the natural unemploym ent rate.The expected inflation rate is 3 percent a year.

The natural unemployment rate is 6 percent.

SHORT-RUN AND LONG-RUN ...The short-run Phillips curve is SRPC0 and the longrun Phillips curve is LRPC0.

An increase in the natural unemployment rate shifts the two Phillips curves rightward to LRPC1 and SRPC1.

SHORT-RUN AND LONG-RUN ...A decrease in the natural unemployment rate shifts the two Phillips curves leftward to LRPC2 and SRPC2.