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SEBI GRADE A 2020: ECONOMICS-Inflation & Phillips Curve

The document discusses the relationship between unemployment and inflation, known as the Phillips Curve. It presents the monetarist view that in the long run, there is no trade-off between unemployment and inflation as increases in aggregate demand will only temporarily lower unemployment and ultimately only cause inflation. The Phillips Curve can shift due to factors like supply shocks or changes in inflation expectations. While short-term trade-offs may exist, policymakers should aim for steady economic growth and supply-side reforms to achieve low and stable rates of both unemployment and inflation.

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Thabarak Shaikh
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214 views

SEBI GRADE A 2020: ECONOMICS-Inflation & Phillips Curve

The document discusses the relationship between unemployment and inflation, known as the Phillips Curve. It presents the monetarist view that in the long run, there is no trade-off between unemployment and inflation as increases in aggregate demand will only temporarily lower unemployment and ultimately only cause inflation. The Phillips Curve can shift due to factors like supply shocks or changes in inflation expectations. While short-term trade-offs may exist, policymakers should aim for steady economic growth and supply-side reforms to achieve low and stable rates of both unemployment and inflation.

Uploaded by

Thabarak Shaikh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve

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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve
Table of Content

Why is there a trade-off between unemployment and inflation? ............................................ 3


Monetarist View of Phillips Curve ..................................................................................... 4
Monetarist view of AD / AS .......................................................................................................................4
The Phillips Curve Breakdown.......................................................................................... 5
Shift in Phillips Curve to the right ..........................................................................................................5
Shift in Phillips Curve to the left .............................................................................................................6
Conclusion ................................................................................................................... 6

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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve
Phillips Curve
Phillips Curve shows that there is an inverse relationship between the rate of
unemployment and the rate of increase in nominal wages. A.W. Phillips has come
up with this concept that there is a tradeoff between wage inflation and unemployment.
In other words, a lower rate of unemployment is associated with higher wage rate or
inflation and vice versa. Have a look at the figure below:

During the 1950s and 1960s, this theory suggested that policymakers could use fiscal and
monetary policy to influence the rate of economic growth and inflation. But in the 1970s
a new situation of stagflation emerged suggesting high unemployment and high
inflation at the same time. This seemed to be a breakdown in the Phillips curve and
some monetary economists criticised it saying that there was no trade-off between
unemployment and inflation in the long run. However, it is believed that Phillips curve still
has some relevance in understanding the trade-off between unemployment and inflation.

Why is there a trade-off between unemployment and


inflation?
When the aggregate demand is increased from
AD to AD2, it causes higher real GDP (Y1 to Y2).
Therefore, firms employ more workers and
unemployment falls. However, as the economy
gets closer to its full capacity, there will be an
increase in the inflationary pressures. And with
lower unemployment, workers are in a
position to demand higher money wages,
which causes wage inflation. Also, firms can

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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve
increase prices due to rising demand. So, in this case, unemployment decreases but
inflation increases.

Monetarist View of Phillips Curve


Monetarists have always been critical of this Phillips curve trade-off. They argue that in
the long run there is no trade-off as Long Run AS (Aggregate Supply) is inelastic.

Monetarists also argue that if there is an increase in aggregate demand, workers will
demand higher nominal wages. When they receive higher nominal wages, they work
longer hours as they feel that real wages have increased compared to their expectations
based on last year. However, this increase in AD causes inflation, and therefore, real
wages stay the same. When they realise real wages are the same as last year, they change
their price expectations, and no longer supply extra labour and the real output returns to
its original level. Therefore, unemployment remains unchanged, but we have a
higher inflation rate. The short-run Phillips curve shifts upwards to SRPC 2 in the figure
below.

Monetarist view of AD / AS

The increase in AD only causes a temporary increase in real output to Y1. After inflation
expectations increase, SRAS (Short-Run Aggregate Supply) shifts to left (SRAS2), and we
end up with higher inflation (P3) and output of Y1 in the figure above. This AD/AS model
explains why we only get a temporary fall in unemployment. However, rational
expectation monetarists argue that there is no trade-off, even in the short term. The
rational expectation model suggests that workers see an increase in AD as inflationary
and so predict real wages will stay the same.

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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve

The Phillips Curve Breakdown


US Data from 1970s simply suggested that the trade-off between unemployment and
inflation had broken down. 1970s saw rising unemployment and inflation- also known as
stagflation. Monetarists argued that increasing the money supply just led to a wage
inflation spiral and did not help to reduce unemployment. They advocated reducing the
money supply and achieving low inflation– any unemployment would just prove
temporary. However, others argued there was still a trade-off- the Phillips curve had just
shifted to the right giving a worse trade-off because of cost-push inflation.

Shift in Phillips Curve to the right


Taking the example of UK, In the early 2000s, the trade-off seemed to improve. Helped
by low global inflation, the unemployment fell without any rise in inflation. Some argued
that this period of stability had ended the boom and bust cycles with the classic trade-off
between inflation and unemployment.

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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve

Shift in Phillips Curve to the left


There was a rise in unemployment rate and a fall in inflation in late 2008 due to recession
and falling oil prices in the UK. But in 2010-11, it experienced higher unemployment and
higher inflation because of cost-push inflationary pressures. This was another period of
stagflation.

Conclusion
A significant increase in aggregate demand is likely to cause a reduction in unemployment
and higher inflation if the economy is operating below full capacity. In short term, there
can be a trade-off between unemployment and inflation. However, questions are raised
whether this policy is valid for the long term. Monetarists, on the one hand, argue

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SEBI GRADE A 2020: ECONOMICS- Inflation & Phillips Curve
that the trade-off will prove short term, and we will just get inflation. However,
Keynesians on the other hand, argue that demand deficient unemployment could
persist in the long term. If there is a significant negative output gap, boosting the
aggregate demand could lead to lower unemployment and a modest increase in inflation.
In a deep recession, this fall in unemployment will not just be temporary because there
will be no crowding out.
In an ideal scenario, policymakers will aim for low inflation and low unemployment. To
achieve this, sustainable economic growth (close to long-run trend rate) and supply-side
policies to reduce cost-push inflation and structural unemployment are needed. If these
criteria are met, then it becomes easier to achieve this goal of lower inflation and lower
unemployment.

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