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Phillips Curve

Phillips Curve

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14/7/08 10:57 AMPhillips curve - Wikipedia, the free encyclopediaPage 1 of 11http://en.wikipedia.org/w/index.php?title=Phillips_curve&printable=yes
Phillips curve
From Wikipedia, the free encyclopedia
The
Phillips curve
is a historical inverse relation between the rate of unemployment andthe rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, thehigher the rate of increase in wages paid to labor in that economy.
Contents
1 History2 Stagflation3 NAIRU and rational expectations4 The Phillips curve today4.1 Gordon's triangle model5Theoretical questions6Mathematicsbehind the Phillips curve6.1 The Traditional Phillips Curve6.1.1 Money Wage Determination6.1.2 Pricing Decisions6.1.3 The Price Phillips Curves6.2 New Classical Version7 Seealso8References9 Further reading10 External links
History
Alban William Phillips, a New Zealand-born economist, wrote a paperin 1958 titled
The Relationship between Unemployment and the Rate of Change o f Money Wages in the United Kingdom 1861-1957 
, which waspublished in the quarterly journal
 Economica
. In the paperPhillipsdescribes how he observed an inverse relationship between moneywage changes and unemployment in the British economy over theperiod examined. Similar patterns were found in other countries and in1960 Paul Samuelson and Robert Solow took Phillips' work and madeexplicit the link between inflation and unemployment: when inflationwas high, unemployment was low, and vice-versa.In the 1920s an American economist Irving Fisher noted this kind of Phillips curve relationship. However, Phillips' original curve describedthe behavior of money wages. So some believe that the Phillips curve 
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14/7/08 10:57 AMPhillips curve - Wikipedia, the free encyclopediaPage 2 of 11http://en.wikipedia.org/w/index.php?title=Phillips_curve&printable=yes
should be called the "Fisher curve."In the years following Phillips' 1958 paper, many economists in theadvanced industrial countries believed that his results showed that therewas a permanently stable relationship between inflation andunemployment. One implication of this for government policy was thatgovernments could control unemployment and inflation within a Keynesian policy. They could tolerate areasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy (i.e., deficitspending) could be used to stimulate the economy, raising gross domestic product and lowering theunemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.During the 1960s, a leftward movement along the Phillips curve described the path of the U.S. economy.This move was not a matter of 
deciding
to achieve low unemployment as much as an unplanned side-effectof the Vietnam war. In other countries, the economic boom was more the result of conscious policies.
Stagflation
In the 1970s, many countries experienced high levels of both inflation and unemployment also known asstagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve cameunder concerted attack from a group of economists headed by Milton Friedman—arguing that thedemonstrable failure of the relationship demanded a return to non-interventionist, free market policies. Theidea that there was a simple, predictable, and persistent relationship between inflation and unemploymentwas abandoned by most if not all macroeconomists.
NAIRU and rational expectations
New theories, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain howstagflation could occur. The latter theory, also known as the "naturalrate of unemployment", distinguished between the "short-term" Phillipscurve and the "long-term" one. The short-term Phillips Curve lookedlike a normal Phillips Curve, but shifted in the long run as expectationschanged. In the long run, only a single rate of unemployment (theNAIRU or "natural" rate) was consistent with a stable inflation rate.The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the NobelPrize in Economics in 2006 for this.In the diagram, the long-run Phillips curve is the vertical red line. TheNAIRU theory says that when unemployment is at the rate defined bythis line, inflation will be stable. However, in the short-runpolicymakers will face an inflation-unemployment rate tradeoff markedby the "Initial Short-Run Phillips Curve" in the graph. Policymakerscan therefore reduce the unemployment rate temporarily, moving from point
A
to point
B
throughexpansionary policy. However, according to the NAIRU, exploiting this short-run tradeoff will raise 
Rate of Change of Wages againstUnemployment, United Kingdom1913-1948 from Phillips (1958)Short-Run Phillips Curve beforeand after Expansionary Policy,with Long-Run Phillips Curve(NAIRU)
 
14/7/08 10:57 AMPhillips curve - Wikipedia, the free encyclopediaPage 3 of 11http://en.wikipedia.org/w/index.php?title=Phillips_curve&printable=yes
inflation expectations, shifting the short-run curve rightward to the "New Short-Run Phillips Curve" andmoving the point of equilibrium from
B
to
C
. Thus the reduction in unemployment below the "NaturalRate" will be temporary, and lead only to higher inflation in the long run.Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionarypolicy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results inmore inflation at each short-run unemployment rate. The name "NAIRU" arises because with actualunemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates.With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for Stagflation, which confounded the traditional Phillips curve.The rational expectations theory said that expectations of inflation were equal to what actually happened,with some minor and temporary errors. This in turn suggested that the short-run period was so short that itwas non-existent: any effort to reduce unemployment below the NAIRU, for example, would
immediately
cause inflationary expectations to rise and thus imply that the policy would fail. Unemployment wouldnever deviate from the NAIRU except due to random and transitory mistakes in developing expectationsabout future inflation rates. In this perspective, any deviation of the actual unemployment rate from theNAIRU was an illusion.However, in the 1990s in the U.S., it became increasingly clear that the NAIRU did not have a uniqueequilibrium and could change in unpredictable ways. In the late 1990s, the actual unemployment rate fellbelow 4 % of the labor force, much lower than almost all estimates of the NAIRU. But inflation stayedvery moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so didthe NAIRU.Further, the concept of rational expectations had become subject to much doubt when it became clear thatthe main assumption of models based on it was that there exists a single (unique) equilibrium in theeconomy that is set ahead of time, determined independent of demand conditions. The experience of the1990s suggests that this assumption cannot be sustained.
The Phillips curve today
Most economists no longer use the Phillips curve in its original form because it was shown to be toosimplistic. This can be seen in a cursory analysis of US inflation and unemployment data 1953-92. There isno single curve that will fit the data, but there are three rough aggregations—1955-71, 1974-84, and 1985-92—each of which shows a general, downwards slope, but at three very different levels with the shiftsoccurring abruptly. The data for 1953-54 and 1972-73 does not group easily and a more formal analysisposits up to five groups/curves over the period.But still today, modified forms of the Phillips Curve that take inflationary expectations into account remaininfluential. The theory goes under several names, with some variation in its details, but all modern versionsdistinguish between short-run and long-run effects on unemployment. The "short-run Phillips curve" is alsocalled the "expectations-augmented Phillips curve", since it shifts up when inflationary expectations rise,Edmund Phelps and Milton Friedman argued. In the long run, this implies that monetary policy cannotaffect unemployment, which adjusts back to its "natural rate", also called the "NAIRU" or "long-runPhillips curve". However, this long-run "neutrality" of monetary policy does allow for short runfluctuations and the ability of the monetary authority to temporarily decrease unemployment by increasinginflation, and vice versa. Blanchard (2000, chapter 8) gives a textbook presentation of the expectations- 

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