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Phillips Curve

by: savills

Phillips Curve Econ101


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About this Document

trade-off between unemployment and inflation
Principles of Macroeconomics
Dr. Kristen Kling
Study Guide
50 ?




Popular in Principles of Macroeconomics

Popular in Macro Economics

This 2 page Study Guide was uploaded by savills on Thursday September 22, 2016. The Study Guide belongs to Econ101 at Arizona State University taught by Dr. Kristen Kling in Fall 2016. Since its upload, it has received 8 views. For similar materials see Principles of Macroeconomics in Macro Economics at Arizona State University.


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Date Created: 09/22/16
The original Phillips Curve shows an inverse relationship between unemployment and inflation. When the economy is weak and unemployment is high, inflation is low. When the economy is strong and unemployment is low, inflation is high. This relationship was based on observations made of unemployment and changes in wage levels from 1861 to 1957. There appeared to be a trade­off between unemployment and inflation, so that any attempt by governments to reduce unemployment was likely to lead to increased inflation. This relationship was seen by Keynesians as a justification of their policies. However, in the 1970s, the relationship appears to break down as the economy suffered from unemployment and inflation rising together (stagflation). In response to the existence of rising inflation and rising unemployment,  Milton Friedman  developed   a   variation   on   the   original   Phillips   Curve   called   the Expectations­Augmented Phillips Curve. Expectations­Augmented Phillips Curve The   Phillips   Curve   showed   a   trade­off   between   unemployment   and   inflation. However, the problem that emerged with it in the 1970s was its total inability to explain unemployment and inflation going up together ­ stagflation. Friedman came up with the explanation that included the role of expectations in the Phillips Curve ­ hence the name 'expectations­augmented'. Friedman argued that there were a series of different Phillips curves for each level of expected inflation. If people expected inflation, then they would anticipate and expect a correspondingly higher wage rise. Friedman was therefore assuming no 'money illusion' ­ people would anticipate inflation and account for it. We therefore get the situation shown below. Unemployment Say the economy starts at point UN with expected inflation at 0%, and the government decides that they want to lower the level of unemployment because it is too high. They therefore decide to boost demand by 3%. The attempt to reduce unemployment would primarily be through boosting aggregate demand (AD) in some way. In the short run, the increase in AD would lead to a rise in national income and subsequently we might expect unemployment to fall. This is represented by a movement along the Philips curve (SRPC(P  E 0)) from point A to point B.  1 However, the adjustment period would also mean that there would be shortages in the economy which would 'pull' prices up. The increase in these prices leads workers to seek wage demands that give them a 'real' increase, i.e. an increase above inflation. Since inflation has risen, workers could reasonably be expected to build an anticipated inflation rate into their wage demands. If these wage demands were granted (and in the days of powerful trade unions and without the emphasis on global competition as there is now) this was very likely, the result would be increased costs for businesses. The increased costs caused the AS curve to shift to the left and the economy would be at point C. Firms would push up prices to maintain their profit margins or shed labour in response to the additional demand and higher costs and the net result would be the economy moving back to the unemployment level it started with (U ) but Nith a higher level of inflation (3%). The increase in demand for goods and services will fairly soon begin to lead to rising prices, and so any increase in employment will quickly be wiped out as people realized that there has not been a real increase in demand. So having moved along the Phillips curve from A to B, the firms now begin to lay people off once again and unemployment moves back to C. Next time around, the firms and consumers are ready for this and anticipate the inflation. If the government insist on trying again to reduce the unemployment, the economy will do the same thing (C to D to E), but this time at a higher and higher levels of inflation. In future wage negotiations, they may not push just for a 3% increase in wages but a higher %. They might think that given that inflation had risen by 3% last year, it might rise by 5% next and so put in for a wage rise of 8% to ensure they get a real pay increase plus cover them for any anticipated inflation. The result is that any attempt to reduce inflation below the level U  will simply be N inflationary. For this reason the rate U N is often known as the  Natural Rate of Unemployment. 2


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