Type: Research Essays
Sample donated: Natasha Burke
Last updated: February 17, 2019
This essayrepresents a summarization of the evolution of the Phillips Curve throughhistory, the utility of it and what it represents as a whole. According to the Phillips Curve there is a negativerelationship between inflation rate and unemployment rate: once unemployment ishigh, inflation tends to be low and the other way around.
The connection between inflation and unemploymentwas observed throughout time by numerous countries but the most important casestudy conducted regarding inflation and unemployment was done by WilliamPhillips in 1958 when he checked out historical information for the UnitedKingdom and published his findings regarding to an inverse interaction betweenwage changes and unemployment . In 1960, two economists Paul Samuelson andRobert Solow continued Phillips’ work to point out the relation betweeninflation and unemployment. Inflation itself is the rate at which the costs formerchandise and services increases and therefore the power of purchashingcurrency shrinks. A possible economic policy conclusion is that fiscaland monetary policy might be used to reduce inflation at the cost of loweredemployment 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 usethe Phillips Curve to control unemployment and inflation. From the 1970, thePhillips Curve became unstable and not usable for policy purposes. As an example , the first part of the graph shows asituation where the economy confronts high unemployment and low inflation.
Thus,policymakers decide that the output is prioritized by cutting taxes andincreasing government spending to stimulate the demand . However there is alimit to how much the output can be increased because when that limit isreached , even a small decrease in demand leads to inflation . Policymakerswould prefer a case where both unemployment and inflation are low but accordingto historical research ,that is impossible. The situation that happened in 1970’s is calledstagflation which resulted in both high unemployment and high inflation .Stagflation appears when the economic growth is slow and the unemployment ishigh which leads to a rise in prices ,therefore the economy stagnates but theprices .This thing happened because in the Phillips’ theory , wages rise asunemployment goes down whereas in the counter theory , wages rise with bothinflation and high unemployment. In the long-run Phillips curve , there is norelation between inflation and unemployment.
The natural rate of unemployment isrepresented by the people who would want a job at a given wage minus those who wouldaccept the job . In this diagram , this difference is shown by Q2-Q1. NAIRU , which is the non-accelerating inflationrate of unemployment shows the rate of unemployment that would stabilise theinflation . The NAIRU theory explained the stagflation event in the 1970’s whenthe Phillips Curve failed to do so. This theory explains the fact that therecan be situations when high unemployment and high inflation can coexist in thesame time because workers can change their inflation expectations , consequentlychanging the predominant inflation rate .
This proved that the Phillips Curve isnot as stable as it looked like . However, in the short run there is a trade-offbetween inflation and unemployment, where an increase in unemployment diminishesthe inflation rate, but not in the long run were these two are not related. Thistrade-off exists only in the short run because workers realise that theirnominal wage will change when the inflation increases as real wages decreaseconsequently . Therefore , workers will ask for a higher real wage so thattheir nominal wage will remain unchanged . This leads to a higher productioncosts and smaller profits. Monetarists do believe that the long run isless elastic than the short one because when more people are employed there isan increased aggregate demand and therefore they demand higher nominal wages.
As the matter of exploiting the Phillips Curve ,itbecame accepted the fact that policy-makers can exploit the trade off betweenunemployment and inflation because more unemployment means less inflation . The short-run Phillips curve depicts the relationshipbetween inflation and unemployment rates. The long run Phillips curve is avertical line that shows there isn’t a constant trade-off between inflation andunemployment whereas the short run Phillips curve iis differently shaped,looking like an L.The PhilipsCurve says that in theory when the unemployment rises the inflation has a falland the other way around, but unlike the long run, in the short run thereexists a more clearer trade-off point because companies employ more peopletherefore the employment falls, but then the wages rise because workers aredemanding therefore inflation rises. For instance in the United States between 1979 and 1983 we can observe a fallfrom 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 wereright and have been used and this is just one particular example for when theshort run has been used. The diagram contrasts the short-run Phillips Curve withthe 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 thatthere exist a trade-off between inflation and unemployment rate . Therefore theshort run of the Phillips’ curve shows that there exists an inverse correlationbetween unemployment rate and inflation.
But this is only available for theshort run, because the history proved multiple times that in the long run itdoes not have the same effect.The Phillips Curve effect can be explained through AS-ADanalysis too. Taking a simple example and assuming that the economy is in equilibriumat Y, an increase in government spending will shift AD to AD1, leading to arise 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, butwith a higher price level of P2.Policymakers can use monetary and fiscal policies in order torise the employment lever and the output and that would result in a rapidlyincreased price level. When policymakers decide a specific point on thePhillips Curve, they can use any monetary and fiscal policy to get to thatpoint.
This view is supported by theexample that between 2011 and 2016 in UK the unemployment rate and theinflation have fallen. This may all have occurred due to the post-brexitperiod, rather than the demand and pull pressures.This does not mean that thePhillips Curve relationship is not available anymore. Between 2007 and 2009 theunemployment rose and the inflation fell, and now, the post-brexit period isshowing the same characteristics.Lower interest rates make itcheaper to borrow. This tends to encourage spending and investment.
This leadsto higher aggregate demand (AD) and economic growth. This increase in AD mayalso cause inflationary pressures.In theory, lower interestrates will reduce the incentive to save (it will encourage consumers to spendrather than hold), will make the cost of borrowing cheaper, will reduce themonthly cost of mortgage repayments , will make it more attractive to buyassets such as housing. Also it can create a depreciation in the exchange rateIfthe UK reduce interest rates, it makes it relatively less attractive tosave money in the UK (you would get a better rate of return in anothercountry).
Therefore there will be less demand for the Pound Sterling causing afall in its value. A fall in the exchange rate makes UK exports morecompetitive and imports more expensive. This also helps to increase aggregatedemand.Overall, lower interest ratesshould cause a rise in Aggregate Demand (AD) = C + I + G + X – M Lower interestrates help increase (C), (I) and (X-M)AD/AS diagram showing effect of a cut in interestratesIf lower interest rates cause a rise in AD, then it will leadto an increase in real GDP (higher rate of economic growth) and an increase inthe inflation rate