represents a summarization of the evolution of the Phillips Curve through
history, the utility of it and what it represents as a whole.
According to the Phillips Curve there is a negative
relationship between inflation rate and unemployment rate: once unemployment is
high, inflation tends to be low and the other way around.
The connection between inflation and unemployment
was observed throughout time by numerous countries but the most important case
study conducted regarding inflation and unemployment was done by William
Phillips in 1958 when he checked out historical information for the United
Kingdom and published his findings regarding to an inverse interaction between
wage changes and unemployment . In 1960, two economists Paul Samuelson and
Robert Solow continued Phillips’ work to point out the relation between
inflation and unemployment. Inflation itself is the rate at which the costs for
merchandise and services increases and therefore the power of purchashing
A possible economic policy conclusion is that fiscal
and monetary policy might be used to reduce inflation at the cost of lowered
employment or it can attain full employment if the cost of price level is high.
However , the relationship was proved to be wrong when governments tried to use
the Phillips Curve to control unemployment and inflation. From the 1970, the
Phillips Curve became unstable and not usable for policy purposes.
As an example , the first part of the graph shows a
situation where the economy confronts high unemployment and low inflation.Thus,
policymakers decide that the output is prioritized by cutting taxes and
increasing government spending to stimulate the demand . However there is a
limit to how much the output can be increased because when that limit is
reached , even a small decrease in demand leads to inflation . Policymakers
would prefer a case where both unemployment and inflation are low but according
to historical research ,that is impossible.
The situation that happened in 1970’s is called
stagflation which resulted in both high unemployment and high inflation .
Stagflation appears when the economic growth is slow and the unemployment is
high which leads to a rise in prices ,therefore the economy stagnates but the
prices .This thing happened because in the Phillips’ theory , wages rise as
unemployment goes down whereas in the counter theory , wages rise with both
inflation and high unemployment.
In the long-run Phillips curve , there is no
relation between inflation and unemployment. The natural rate of unemployment is
represented by the people who would want a job at a given wage minus those who would
accept the job . In this diagram , this difference is shown by Q2-Q1.
NAIRU , which is the non-accelerating inflation
rate of unemployment shows the rate of unemployment that would stabilise the
inflation . The NAIRU theory explained the stagflation event in the 1970’s when
the Phillips Curve failed to do so. This theory explains the fact that there
can be situations when high unemployment and high inflation can coexist in the
same time because workers can change their inflation expectations , consequently
changing the predominant inflation rate . This proved that the Phillips Curve is
not as stable as it looked like .
However, in the short run there is a trade-off
between inflation and unemployment, where an increase in unemployment diminishes
the inflation rate, but not in the long run were these two are not related. This
trade-off exists only in the short run because workers realise that their
nominal wage will change when the inflation increases as real wages decrease
consequently . Therefore , workers will ask for a higher real wage so that
their nominal wage will remain unchanged . This leads to a higher production
costs and smaller profits.
Monetarists do believe that the long run is
less elastic than the short one because when more people are employed there is
an increased aggregate demand and therefore they demand higher nominal wages.
As the matter of exploiting the Phillips Curve ,it
became accepted the fact that policy-makers can exploit the trade off between
unemployment and inflation because more unemployment means less inflation .
The short-run Phillips curve depicts the relationship
between inflation and unemployment rates. The long run Phillips curve is a
vertical line that shows there isn’t a constant trade-off between inflation and
unemployment whereas the short run Phillips curve iis differently shaped,
looking like an L.
Curve says that in theory when the unemployment rises the inflation has a fall
and the other way around, but unlike the long run, in the short run there
exists a more clearer trade-off point because companies employ more people
therefore the employment falls, but then the wages rise because workers are
demanding therefore inflation rises.
For instance in the United States between 1979 and 1983 we can observe a fall
from 15% to 2.5% in the inflation and the unemployment rose from 5% to 11%
meaning that the Philips’ research along side with Samuelson’s and Solow’s were
right and have been used and this is just one particular example for when the
short run has been used.
The diagram contrasts the short-run Phillips Curve with
the long-run Phillips curve (in red), which shows that over the long term,
unemployment rate is constant despite the inflation rate.
Briefly , the short run Phillips curve states that
there exist a trade-off between inflation and unemployment rate . Therefore the
short run of the Phillips’ curve shows that there exists an inverse correlation
between unemployment rate and inflation. But this is only available for the
short run, because the history proved multiple times that in the long run it
does not have the same effect.
The Phillips Curve effect can be explained through AS-AD
analysis too. Taking a simple example and assuming that the economy is in equilibrium
at Y, an increase in government spending will shift AD to AD1, leading to a
rise in income to Y1, and a fall in unemployment in the short term.
However, Households will predict the higher price levels and consequently
, wage costs rise and the AS shifts to AS1 and the economy moves back to Y, but
with a higher price level of P2.
Policymakers can use monetary and fiscal policies in order to
rise the employment lever and the output and that would result in a rapidly
increased price level. When policymakers decide a specific point on the
Phillips Curve, they can use any monetary and fiscal policy to get to that
This view is supported by the
example that between 2011 and 2016 in UK the unemployment rate and the
inflation have fallen. This may all have occurred due to the post-brexit
period, rather than the demand and pull pressures.
This does not mean that the
Phillips Curve relationship is not available anymore. Between 2007 and 2009 the
unemployment rose and the inflation fell, and now, the post-brexit period is
showing the same characteristics.
Lower interest rates make it
cheaper to borrow. This tends to encourage spending and investment. This leads
to higher aggregate demand (AD) and economic growth. This increase in AD may
also cause inflationary pressures.
In theory, lower interest
rates will reduce the incentive to save (it will encourage consumers to spend
rather than hold), will make the cost of borrowing cheaper, will reduce the
monthly cost of mortgage repayments , will make it more attractive to buy
assets such as housing. Also it can create a depreciation in the exchange rate
the UK reduce interest rates, it makes it relatively less attractive to
save money in the UK (you would get a better rate of return in another
country). Therefore there will be less demand for the Pound Sterling causing a
fall in its value. A fall in the exchange rate makes UK exports more
competitive and imports more expensive. This also helps to increase aggregate
Overall, lower interest rates
should cause a rise in Aggregate Demand (AD) = C + I + G + X – M Lower interest
rates help increase (C), (I) and (X-M)
AD/AS diagram showing effect of a cut in interest
If lower interest rates cause a rise in AD, then it will lead
to an increase in real GDP (higher rate of economic growth) and an increase in
the inflation rate