The Philips Curve. Aims and Objectives Aim: Understand Philips curve and the augmented Philips curve Objectives: Define Philips Curve Trade Off

The Philips Curve

Aims and Objectives

Aim:Understand Philips curve and the augmented

Philips curve

Objectives: Define Philips Curve Trade OffExplain demand and supply side policies

which could be used to reduce unemploymentAnalyse the usefulness of the Philips CurveEvaluate the augmented Philips curve

Starter‘The appropriate response to combat

cyclical unemployment may be to stimulate AD.

The supply side nature of unemployment needs to be tackled with supply side

policies.’

What demand side & supply side policies can you think of to combat

unemployment?

Demand Side & Supply Side Policies

Demand Side

Fiscal Policy

Make Credit More Available

Use regional policy to combat structural unemployment

Offer firms subsidies to hire workers in depressed regions

Supply Side

Improved education

Increase funding on vocational training

Subsidise housing in cities where accommodation is expensive

Provide tax breaks and tax credits

The Philips Curve

• AW Philips plotted data 1861-1957

• Short run trade off between unemployment and inflation

• Falling unemployment might cause inflation to rise

• Reducing inflation might only be at the expense of increasing unemployment

• Inverse relationship

The Philips Curve• Level of inflation

could be traded off against a level of unemployment.

• Will happen as to reduce unemployment AD must be stimulated which will lead to inflation when there is excess demand/

Infla

tion

%

Unemployment %

SRPC

The Philips Curve• 1970s high inflation and

unemployment co-existed – stagflation.

• On graph paper plot the following data for unemployment and inflation from 1970-1985.

• Does there appear to be any obvious relationship, or had the Philips curve trade off truly broken down?

The Philips CurveYear

Unemployment % of Workforce

Inflation % Change

1970 2.20% 5.90%

1971 2.70% 8.70%

1972 3.10% 6.50%

1973 2.20% 8.40%

1974 2.00% 17.00%

1975 3.20% 23.50%

1976 4.80% 15.70%

1977 5.10% 14.70%

1978 5.00% 9.50%

1979 4.60% 13.70%

1980 5.60% 16.30%

1981 8.90% 11.20%

1982 10.30% 8.70%

1983 11.10% 4.80%

1984 11.10% 5.00%

1985 11.50% 5.30%

The Philips Curve

• Does there appear to be any obvious relationship, or had the Philips curve trade off truly broken down?

0.00%2.00%

4.00%6.00%

8.00%

10.00%

12.00%

14.00%0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Philips Curve

Unemployment % of Workforce

Infla

tion

% C

hang

e

• Produce yourself a set of teaching notes and the Philips Curve.

• You are then to have an economist speed dating session.

• You will have 3 minutes to tell your hot date all about Philips Curve in an attempt to ‘woo’ them with economics knowledge.

• Your date will then score you out of ten.

The Expectations Augmented Philips Curve

Aims and Objectives

Aim:Understand Philips curve and the augmented

Philips curve

Objectives: Define Philips Curve Trade OffExplain demand and supply side policies

which could be used to reduce unemploymentAnalyse the usefulness of the Philips CurveEvaluate the augmented Philips curve


• Monetarist economists were still adamant that the curve existed.

• Milton Friedman accepted that there is a short run Philips Curve but that in the long run it was vertical.

• He suggested that it’s impossible to reduce unemployment in the long run by, for example, increasing the money supply as this will just cause inflation.


• You are walking down a street on your own, you know is a ‘bit dodgy’ to get home after a night out.

• In this street you are mugged and your phone and wallet/purse is stolen and you are left with a black eye.

• The next week you go out again and have the choice of walking down the same street having been ,mugged or going down an alternative street. What do you do?


• Adaptive expectations: where decisions about the future are based upon past information.

• If consumers experience high inflation in one month, they will learn from this and demand higher wages in the next period.

• The result may be that higher unemployment is required to keep inflation at a target level.

• Credible monetary policy may also have the effect of reducing inflation expectations, causing a leftward shift of the SRPC.


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• Economy initially at point A, unemployment at natural rate UN

• At point A the rate of inflation is 0


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• We assume that people form expectations of future inflation on the basis of the current rate of inflation.

• Since current inflation is zero, workers expect future inflation to also be zero.


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• Gov. stimulates AD – movement along the SRPC1 to Pt B.

• Unemployment – U1 and inflation rising to 5%.

• Pt B is unsustainable.


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• For workers to supply more labour the RWR must rise.

• In short run more workers may supply themselves, suffering from money illusion.

• Believing that a 5% increase in wages is also a real increase.


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• For workers to supply more labour the RWR must rise.

• In short run more workers may supply themselves, suffering from money illusion.

• Believing that a 5% increase in wages is also a real increase.


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• Firms may also suffer from money illusion believing that rising prices mean sales revenues are rising faster than labour costs.

• Workers and firms eventually see through money illusion and refuse to supply and demand labour.


Infla

tion

%

Unemployment %

SRPC1

SRPC2

LRPC

CB

U1 UN

A

5%

• Economy now moves to point C but with inflation expectations of 5% now built in.

• Any attempt to boost AD, will result in a movement along SRPC2 and a return the NRU.


• The EAPC suggests that there is no long-run trade off between inflation and unemployment as the LRPC suggests.

• Any attempt to reduce unemployment below NRU by stimulating AD is pointless and governments must tackle supply side causes if they wish to reduce unemployment.

• NRU = voluntary frictional unemployment

• NAIRU= non accelerating inflation rate of unemploymentthe level of U where I does not increase.

The Long Run Philips Curve

• Can shift inward over time.

• Due to supply side improvements in the economy

• Labour market reforms may lead to a reduction in the NRU & NAIRU by improving occupational mobility of labour

• Produce yourself a set of teaching notes and the EAPC.

• You are then to have an economist speed dating session.

• You will have 3 minutes to tell your hot date all about EAPC in an attempt to ‘woo’ them with economics knowledge.

• Your date will then score you out of ten.

Documents

The Philips Curve. Aims and Objectives Aim: Understand Philips curve and the augmented Philips curve Objectives: Define Philips Curve Trade Off