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The Phillips Curve

Macro economics

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Anike Range-Todd
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15 views4 pages

The Phillips Curve

Macro economics

Uploaded by

Anike Range-Todd
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 DOCX, PDF, TXT or read online on Scribd
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The Phillips Curve, Natural rate of Unemployment and inflation - explain

according to Macro economics

The Phillips Curve, natural rate of unemployment, and inflation are


fundamental concepts in macroeconomics that describe the relationship
between inflation and unemployment, and their implications for economic
policy. These concepts help explain the trade-offs that policymakers face
when managing an economy, particularly when trying to control inflation
and reduce unemployment.

1. The Phillips Curve

The Phillips Curve illustrates the inverse relationship between the rate
of inflation and the rate of unemployment in an economy. The curve is
named after economist A.W. Phillips, who, in 1958, found an empirical
inverse relationship between the rate of wage inflation and the
unemployment rate in the UK.

 Short-Run Phillips Curve:

o In the short run, the Phillips Curve suggests that there is a trade-
off between inflation and unemployment. Specifically, when
unemployment is low, there is upward pressure on wages as
employers compete for a smaller pool of workers. Higher wages
lead to higher costs for firms, which are often passed on to
consumers in the form of higher prices (inflation).

o Conversely, when unemployment is high, wage growth slows, and


inflation tends to be lower because there is less demand for goods
and services and less pressure on wages.

 Mathematical Representation: The short-run Phillips Curve is


typically represented as:

where:

Long-Run Phillips Curve:

o In the long run, the relationship between inflation and


unemployment is thought to become vertical at the natural rate
of unemployment (UnU_nUn). In the long term, inflation and
unemployment are not directly related, and attempts to keep
unemployment below the natural rate will only lead to higher
inflation without reducing long-term unemployment.

o The long-run Phillips Curve reflects the view that expectations


of inflation adjust over time, and inflation expectations play a
key role in determining the actual inflation rate.

2. The Natural Rate of Unemployment

The natural rate of unemployment refers to the level of unemployment


that is expected in an economy when it is operating at full potential,
without overheating or underperforming. This rate includes frictional and
structural unemployment but excludes cyclical unemployment.

 Frictional Unemployment: Unemployment that arises from the


process of people moving between jobs or entering the workforce
for the first time.

 Structural Unemployment: Unemployment that occurs when


there is a mismatch between the skills of workers and the demands
of the job market (e.g., technological changes, shifts in demand for
certain industries).

The natural rate of unemployment is influenced by:

 Labor market policies: Such as unemployment benefits, minimum


wages, and labor market regulations.
 Education and training: The skills available in the workforce.

 Technological change: Shifts that can make certain skills obsolete


and create new opportunities.

 Demographic factors: Age, education, and geographic mobility of


the labor force.

The natural rate is considered to be non-accelerating inflation rate


of unemployment (NAIRU), meaning that when unemployment is at this
level, inflation remains stable. If the economy’s unemployment rate falls
below the natural rate, inflation will tend to accelerate as demand for
labor increases and wages rise.

3. Inflation

Inflation refers to the rate at which the general level of prices for goods
and services rises, eroding purchasing power over time. Inflation is
typically measured by indices such as the Consumer Price Index (CPI)
or the Producer Price Index (PPI).

 Demand-Pull Inflation: Occurs when aggregate demand (the total


demand for goods and services in the economy) exceeds aggregate
supply, leading to higher prices. It is often associated with periods of
low unemployment.

 Cost-Push Inflation: Arises when the costs of production (e.g.,


wages, raw materials, energy) increase, leading businesses to raise
their prices in order to maintain profit margins. This can happen
even if demand is stable.

 Built-In (Wage-Price) Inflation: Occurs when workers demand


higher wages to keep up with rising living costs, and businesses
raise prices to compensate for higher wages, leading to a self-
reinforcing cycle of wages and prices.

Inflation can be influenced by:

 Monetary Policy: Central banks control inflation through interest


rates and money supply. High inflation often leads central banks to
raise interest rates to curb spending and investment.

 Fiscal Policy: Government spending and taxation can also impact


inflation. Expansionary fiscal policies (higher spending or lower
taxes) can increase demand and lead to inflationary pressures.
The Phillips Curve, Natural Rate of Unemployment, and Inflation:
Relationship

 Short-Run Trade-Off: The Phillips Curve in the short run implies a


trade-off between inflation and unemployment. A decrease in
unemployment below the natural rate puts upward pressure on
wages and prices, resulting in higher inflation.

 Long-Run Perspective: In the long run, the Phillips Curve becomes


vertical at the natural rate of unemployment. This suggests that any
attempt to push unemployment below the natural rate by using
inflationary policies will only lead to higher inflation, without
reducing unemployment in the long term.

In the long run, people adjust their expectations of inflation, leading to a


situation where any attempt to maintain unemployment below the natural
rate will simply result in accelerating inflation, as the economy moves
toward its natural rate of unemployment.

 Inflation Expectations: A critical aspect of the Phillips Curve is the


role of expectations. If people expect higher inflation in the future,
they will adjust their behavior (e.g., demanding higher wages),
which can shift the short-run Phillips Curve upward. This can make it
more difficult for policymakers to reduce unemployment without
causing higher inflation.

Conclusion

 The Phillips Curve provides a framework for understanding the


trade-off between inflation and unemployment in the short run, but
the relationship is not static and can shift over time based on
expectations and external factors.

 The natural rate of unemployment represents the level of


unemployment that is consistent with stable inflation in the long
run. Attempts to push unemployment below this level can lead to
accelerating inflation.

 Inflation is influenced by demand-pull factors, cost-push factors,


and expectations, and managing inflation is a key goal of both
monetary and fiscal policy.

Understanding the interaction between these concepts helps policymakers


make decisions about how to balance economic growth, employment,
and price stability over the short, medium, and long term.

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