The Phillips Curve

1958 – 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.

The Phillips CurveWage growth % (Inflation)

Unemployment (%)

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

1.5%

6%4%PC1

3.0%

PC2

FREIDMAN’S 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 people’s 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.

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

In the long run, there is no unemployment-inflation tradeoff.

LONG-RUN ...

• 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 upward-sloping 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/AD

Inflation

Real National Income

AD1

AS1

2%

U = 4%

Assume the economy has an inflation rate of 2% and a level of national income giving an unemployment rate of 4%. AD rises for some reason.

AD2

U = 3%

3.75%

The rise in AD leads to a fall in unemployment but inflationary pressures push inflation up to 3.75%. Producers try to expand output but at increased cost – employing more expensive capital, paying workers more to do work etc. Increased cost results in a shift in AS to the left – workers start to be laid off.

AS2

4.0%

The short run fall in unemployment is only temporary; as AS shifts, unemployment will start to rise again and the economy will end up in the long run in a position with unemployment at 4% but with higher inflation. Expansionary fiscal or monetary policy will only lead to reductions in unemployment in the short run. In the long run unemployment will return to its natural rate. Attempts to reduce unemployment below the natural rate will be inflationary.

–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 Rate–If 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.

Figure shows the effect of changes in the natural unemployment rate.The expected inflation rate is 3 percent a year.

SHORT-RUN AND LONG-RUN ...

The natural unemployment rate is 6 percent.

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