Phillips Curve

A. W. Phillips, in his research paper published in 1958, indicated a negative

statistical relationship between the rate of change of money wage and the
unemployment rate.

It was also shown that a similar negative relationship holds for rate of change of
prices (i.e., inflation) and the unemployment level.

This relation is usually generalised in the Phillips curve. Phillips first examined
this negative relationship using data from the UK during the period 1861-1957.

The theory claims that with economic growth comes inflation, which in turn

should lead to more jobs and less unemployment. 

The Phillips curve, drawn in figure, shows that as the unemployment level rises,
the rate of inflation falls. Zero rate of inflation can only be achieved with a high
positive rate of unemployment of, say 5 %, or near full employment situation can
be attained only at the cost of high rate of inflation. Thus, there exists a trade-off
between inflation and unemployment; the higher the inflation rate, the lower
is the unemployment level.
Monetary economist Milton Friedman challenged the concept of stable
relationship between inflation and unemployment rates as shown in Figure.
Friedman argues that such trade-off, i.e., negative relationship between inflation
rate and unemployment—may hold in the short period, but not in the long
run. Price or inflation expectations influence the Phillips curve.

In other words, Phillips curve shifts or changes its position as expectations

regarding price level change. If people expect that inflation in the coming period
will persist, the Phillips curve will shift to the right or if inflationary expectations
show a downward trend, the Phillips curve will then shift its position to the left.

In the short run, Phillips curve may shift either to the right, or to the left if the
relationship between these variables—inflation rate and unemployment rate
—is not stable. In other words, if inflationary expectations are deemed to be
stable, then there would not be any shift in the Phillips curve as such.

Regarding the shifting of the Phillips curve, Friedman considers influence of

inflationary expectations. This is called the theory of ‘adaptive expectations’—
expectations that are altered or ‘adopted’ to experienced events. In the short run,
people make incorrect expectations of the price changes because of incomplete
information. That is why a trade-off relationship emerges.

But in the long run, actual and expected price changes become. This rational
expectations view suggest that people guess future economic events rather
correctly in the long run.

Thus, the impact of expectations, whether adaptive or rational, have an important

bearing on the relationship between inflation and unemployment rates. It is
because of expectation, Friedman argues that there is no trade- off between
inflation and unemployment in the long run.

 ‘natural rate of unemployment’ (NRU)

which was introduced by Friedman. Unemployment is ‘natural’ when some

people either do not get jobs or are unwilling to accept jobs at the equilibrium
real wage. Such a ‘natural’ rate of unemployment, may be considered as a
situation of ‘full employment’ of an economy.

The natural rate of unemployment is the unemployment rate that would exist in a

growing and healthy economy. In other words, the natural rate of unemployment
includes only frictional and structural unemployment, and not cyclical
unemployment.

In Figure below we have drawn the long run Phillips curve as a vertical line
through the ‘natural rate of unemployment’. Further, we have drawn three short
run Phillips curves (SRPC1, SRPC2 and SRPC3) representing different expected
rates of inflation. The curve SRPC1 shows ‘zero’ inflationary expectations (∆Pe = 0
p.c.) and a high rate of unemployment or NRU, UN. SRPC2 shows a high expected
rate of inflation, say 6 p.c. (∆P e= 6 p.c.). SRPC3 shows more higher expected
inflation rate, say 9 p.c. (∆Pe = 9 p.c.).

As people’s expectation about future price level changes, short-run Phillips curve
shifts upwards showing trade-offs between inflation and unemployment. Since, in
the long run expected inflation matches the actual inflation, the long run Phillips
curve i.e., LRPC, becomes vertical at NRU or point UN. It follows then that in the
long run, there is no trade-off between the two.
In the long run, any positive rate of inflation may persist with a natural rate of
unemployment or the non-accelerating inflation rate of unemployment (NAIRU)
i.e., the rate of unemployment at which inflation is neither accelerating or
decelerating.

We assume that the economy initially is at point A at the NRU, i.e., U N with a zero
actual and expected inflation rate. Further, we assume that the government thinks
that this unemployment rate is pretty high and thus, takes step to reduce
unemployment rate to OL. Adoption of policy measures say, expansion in money
supply causes aggregate demand to rise, and thus, wage rate to rise say by 6 %, and
the level of unemployment to drop from OA to OL. This may cause a rise, 6 % in
the price level. The economy then moves from point A to B, thereby suggesting a
higher inflation rate and a lower unemployment rate along the SRPC1.

Since workers expect price level to rise, the Phillips curve will shift upward to the
right. Workers will now pitch a higher demand for wages and, as a consequence, a
higher rate of inflation will appear at any given unemployment rate.

If the same money wage growth is maintained, the economy will come back to
UN i.e., point A, but with an inflation rate of 6 p.c. This long run adjustment helps
to move the economy from point B to point C. Further increase in money supply
will result in temporary reductions in unemployment below the NRU, U N (i.e.,
movement from point C to point D) but at a higher rate of inflation (9%). The
SRPC then shifts to SRPC3, the economy in the long run moves from point D to E.
If the inflation rate is required to be lowered down, policymakers will then be
forced to increase the ‘natural’ rate of unemployment, beyond U N. Then, based on
a lower expected inflation rate, adjustment will take place along SRPC3, from point
E to F. As money wage declines more jobs will be available and unemployment
rate will continue to fall until point C (i.e., natural unemployment rate, U N) on
SRPC2 is reached. Thus, the LRPC is a vertical one through NRU, U N, joining
points A, C, E, and so on.

Inflation

What Is Inflation?
Inflation is a quantitative measure of the rate at which the average price level of
a basket of selected goods and services in an economy increases over a period of
time. It is the constant rise in the general level of prices where a unit of currency
buys less than it did in prior periods. Often expressed as a percentage, inflation
indicates a decrease in the purchasing power of a nation’s currency.
Causes of Inflation

The main causes of inflation are either excess aggregate demand (AD) (economic
growth too fast) or cost push factors (supply-side factors).

AD = C + I + G + NX (X-M)

C = A + bY

1. Demand-pull inflation

If the economy is at or close to full employment, then an increase in aggregate

demand (AD) leads to an increase in the price level (PL). As firms reach full
capacity, they respond by increasing prices leading to inflation. Also, near full
employment with labour shortages, workers can get higher wages which increase
their spending power.

2. Cost-push inflation
If there is an increase in the costs of firms, then businesses will pass this on to
consumers. There will be a shift to the left in the AS.

Cost-push inflation can be caused by many factors

1. Rising wages
If trades unions can present a united front then they can bargain for higher wages.
Rising wages are a key cause of cost push inflation because wages are the most
significant cost for many firms. (higher wages may also contribute to rising
demand)

2. Import prices
If there is a devaluation, then import prices will become more expensive leading to
an increase in inflation. A devaluation / depreciation means the Rupee is worth
less. Therefore we have to pay more to buy the same imported goods.

3. Raw material prices

The best example is the price of oil. If the oil price increase by 20% then this will
have a significant impact on most goods in the economy and this will lead to cost-
push inflation. 

4.   Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to
higher prices.

5. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to
higher prices, and therefore Consumer Price Index will increase. However, these
tax rises are likely to be one-off increases.

8. Printing more money

If the Central Bank prints more money, you would expect to see a rise in inflation.
This is because the money supply plays an important role in determining prices. If
there is more money chasing the same amount of goods, then prices will rise.
Hyperinflation is usually caused by an extreme increase in the money supply.
Consequences of Inflation
Many governments have set their central banks a target for a low but positive rate
of inflation. They believe that persistently high inflation can have damaging
economic and social consequences.

1. Income redistribution: One risk of higher inflation is that it has a

regressive effect on lower-income families and older people in society.
This happen when prices for food and domestic utilities such as water
and heating rises at a rapid rate

2. Falling real incomes: rising inflation leads to a fall in real incomes as the
purchasing power of their income decreases.

3. Negative real interest rates: If interest rates on savings accounts are lower
than the rate of inflation, then people who rely on interest from their savings will
be poorer. Real interest rates for millions of savers in the UK and many other
countries have been negative for at least four years

4. Cost of borrowing: High inflation may also lead to higher borrowing costs
for businesses and people needing loans and mortgages as financial markets protect
themselves against rising prices and increase the cost of borrowing on short and
longer-term debt. There is also pressure on the government to increase the value of
the state pension and unemployment benefits and other welfare payments as the
cost of living climbs higher.

5. Risks of wage inflation: High inflation can lead to an increase in pay claims
as people look to protect their real incomes. This can lead to a rise in unit labour
costs and lower profits for businesses

6. Business competitiveness: If one country has a much higher rate of

inflation than others for a considerable period of time, this will make its exports
less price competitive in world markets. Eventually this may show through in
reduced export orders, lower profits and fewer jobs, and also in a worsening of a
country’s trade balance. A fall in exports can trigger negative multiplier and
accelerator effects on national income and employment.

7. Business uncertainty: High and volatile inflation is not good for business
confidence partly because they cannot be sure of what their costs and prices are
likely to be. This uncertainty might lead to a lower level of capital investment
spending.

Policies to reduce inflation

1. Monetary Policy 

Monetary policy is the most important tool for maintaining low inflation.  In India,
monetary policy is set by the monetary policy committee (MPC) of RBI. They
are given an inflation target by the government. The MPC use interest rates to
try and achieve this target.

The first step is for the MPC to try and predict future inflation. They look at
various economic statistics and try to decide whether the economy is overheating.
If inflation is forecast to increase above the target, the MPC are likely to
increase interest rates.

Increased interest rates will help reduce the growth of aggregate demand in
the economy. The slower growth will then lead to lower inflation. Higher
interest rates reduce consumer spending because:

 Increased interest rates increase the cost of borrowing, discouraging

consumers from borrowing and spending.
 Increased interest rates make it more attractive to save money
 Increased interest rates reduce the disposable income of those with
mortgages.
  Higher interest rates increased the value of the exchange rate leading to
lower exports and more imports.

Diagram showing fall in AD to reduce inflation

2. Supply-Side Policies

Supply-side policies aim to increase long term competitiveness and

productivity. For example, it was expected that privatisation and deregulation
would make firms more productive and competitive. Therefore, in the long
run, supply-side policies can help reduce inflationary pressures.

 However, supply-side policies work very much in the long term; they
cannot be used to reduce sudden increases in the inflation rate. Also, there
is no guarantee government supply-side policies will be successful in
reducing inflation

3. Fiscal Policy 
This is another demand-side policy, similar in effect to monetary policy. Fiscal
policy involves the government changing tax and spending levels in order to
influence the level of Aggregate Demand. To reduce inflationary pressures the
government can increase tax and reduce government spending. This will
reduce AD.

4. Exchange rate policy

keeping the value of the rupee high, it would help reduce inflationary pressures.

 A stronger rupee makes imports cheaper (lower cost-push inflation)

 Stronger rupee reduces domestic demand, leading to less demand-pull
inflation.
 A stronger rupee creates incentives for firms to cut costs in order to
remain competitive.

5. Wage Control
Wage growth is a key factor in determining inflation. If wages increase quickly, it
will cause high inflation.