Continuous Assessment # 1

Evolution of Phillip’s curve & its applicability to Indian Scenario

Subject: Macro Economics

Submitted to: Prof (Dr) Sudip Patra, Jindal Global Business School, JGU

Submitted By: Amrinder Singh, 19020321, MBA 19-21, JGBS

Dated: 14th May 2020

Assignment 1, Macro-Economics

A. Sketch a short essay on the evolution of Phillip’s curve model over decades, clearly
specifying the assumptions, methods and equations of respective models.
Differentiate between Samuelson-Solow approach from the Friedman-Phelps
approach. (max 1000 words).

The Phillips Curve has been one of the most revered macroeconomic theories of the 21st
century. Seven Nobel Prizes have been awarded to works, to either variation or critiques of
the Phillips Curve. Though not intended as policy tool by Phillips himself, the original form
was an empirical study of the correlation between wage inflation and rate of unemployment
in Britain. (Schwarzer, 2013)

In the modern form, it provides the link between nominal variables, like price and wage
inflation, and the real economy. In other words, it shows how changes in nominal income are
translated into changes in prices and quantities. The nature of the Phillips curve
fundamentally determines that how the interaction of demand and supply in the economy will
affect nominal and real variables, so it is of crucial importance for economic policymakers to
be aware of the true nature of this relation. Provided policymakers can influence aggregate
demand in the economy, then depending on the behaviour of aggregate supply, as captured by
the Phillips curve, their actions can have radically different consequences on real output and
inflation. (Motyovszki, 2013)

Classical view:

The neoclassical economics was based on the Aggregate Supply and Demand framework, that
believed that the “supply always creates its own demand” through the instantaneous adjustment of
prices. The real output is given by the Aggregate Supply, which is a function of labour, capital and
productivity. Any change or shock in the aggregate demand would only affect the prices, however the
real variables remain unchanged. Hence the aggregate supply curve can be considered as a vertical
line denoting potential output or long
run steady state output, any shifts in
the aggregate demand along the
vertical aggregate supply line will
result in changes in price levels only.

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Assignment 1, Macro-Economics

This framework also leads to Classical dichotomy, implying that the economy could be spilt into real
and nominal sectors without any interaction between the two. Any abrupt changes in the nominal
variable could hence not affect the real variables. Since the real output of the economy is a function of
real fundamentals of supply side, any changes in the quantity of money would not have any effect on
the real demand. Therefore, changes in nominal demand due to change in quantity of money will be
only lead to changes only in the price level, not in the real output. This is known as the “Neutrality of
monetary policy”.

Keynesian View:

British politician and economist, John Maynard Keynes, gave insights into the short run behavior of
economic activity, inspired by the Great Depression of 1929-1932. He suggested that the real
economic activity is demand driven in the short run instead of supply potential. He proposed that the
prices remain sticky and perfectly fixed in the short run, it will be aggregate demand that will drive
the real output while the prices remain unchanged.

This implies that the aggregate

supply curve would be horizontal,
indicating a fixed price while the
demand can shift along its negatively
sloped curve. This effectively
neutralizes the neoclassical concepts
of dichotomy and monetary neutrality
as the changes in nominal variables to
shift the demand would now translate
into change in real variables like
output and prices would remain
constant.
Figure 2: The keynesian View

Both the neoclassical and Keynesian theories failed to connect price and real output. This was until
1958, when A.W. Phillips published a paper in Economica, titled “The Relationship between
Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861 –
1957”. In the paper, Phillips established a negative non-linear correlation between the rate of
unemployment and the rate of inflation - the years with high unemployment showed low inflation
and the years with low unemployment experienced high inflation. This resulted in a downward
sloping convex curve, which intersected the horizontal axis at some positive level of unemployment.

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Assignment 1, Macro-Economics

It hence established an empirical relationship between change of wage rate and inverse of change of
employment rate.

dw /w ∝1/( du/dt ) (0)

If we were to take the change of wage rate and inverse of change of employment rate as proxies for
price inflation and real output, there exists a positive relationship between inflation and real output.
Hence we have a aggregate supply curve with a positive and finite slope along the negatively sloped
Phillips curve.

Here an increase in the aggregate demand cause increase in output, with firms employing more and
resulting in fall of unemployment rate. If the demand keeps on increasing, there is pressure on the rate
of excess demand for labour. This demand increase leads labour to demand higher money wages,
causing wage inflation as well as increase in price of goods. This is the situation with lower
unemployment rate and higher inflation. However, this increase in demand of labour is neither
captured by price increases or by output growth. Workers suffer from the illusion, wrongly perceiving
the change in nominal wages as increase in their real wage, without any compensation of price
inflation. With increase in nominal wages, workers supply more labour while the firms demand more
labour due to decrease in real wages. While this leads to unemployment, the wages turn relatively
sticky in this scenario. This is manifested in Samuelson- Solow ‘s Phillips Curve:

Samuelson – Solow Phillip curve equation:

π=π e +bu(−1)−(1−β ) λ (0)

Where π = Inflation rate, πe = expected inflation rate

λ = Rate of labour productivity, bu(−1)=demand pressure

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Assignment 1, Macro-Economics

This equation led to generalization of Phillips curve that it represented a stable trade-off between
inflation and unemployment, which further lead to the belief that by generating and maintaining
excess demand, unemployment could be lowered at the cost of higher inflation. The real output was
considered to be moving along the Phillips Curve.

According to Freidman and Phelps the natural rate of unemployment cannot be influenced by demand
side policies, it is determined by the structural features of the labour market.

Shifts in the Phillips curve: The role of expectations

US economist Milton Friedman and Edmund Phelps in two separate research articles argued that
Phillips curve is for short run and the balance between unemployment and inflation could not be
manipulated using monetary policies. In the long run, it is monetary neutral. Since increase in money
supply effect prices and income, and does not impact the unemployment. Thus the Phillips Curve

Figure 3: Phillips Curve in the Long Run

could be thought of a straight line at the natural unemployment rate – the rate of unemployment when
the labour market is in equilibrium.

A vertical long run Phillips Curve follows a vertical long run aggregate supply curve. As the money
supply increases in the log run, the aggregate demand also increases resulting in shift of demand curve
to the right. As the aggregate supply in constant in long term, shifting of the aggregate demand curve
increases the economy to from point A to point C (refer figure 3, panel A). As per the assumption of
monetary neutrality, the income and price move in tandem. Any increase in the money supply
resulting in increase of output would increase the inflation and counter the rate of unemployment.

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Assignment 1, Macro-Economics

NAIRU – non-accelerating inflation rate of unemployment is the rate of employment consistent with
stable rate of inflation. The inflation has significant impact on the unemployment in the short run. The
short run aggregate supply curve assumes that price expectations do not change. If the price
expectations are fixed in the short run, a higher inflation would result in higher output and rate of
unemployment lower than natural rate of employment, indicating movement from point A to point B.
This increase in inflation rate is unstable and the short run Phillips curve will move from point B to
point C, i.e. raised expectations adjust the higher rate of inflation. Thus unemployment rate reverts to
the natural rate of unemployment at the long run Phillips Curve once the inflation is fully anticipated.
This is called natural rate hypothesis.

Figure 4: Long run Phillips Curve and NAIRU

The analysis of the Friedman and Phelps can be summarized as:

Rate of Unemployment=Natural rate of Unemployment−α (actual inflation−expected inflation)

Shifts in the Phillips curve: The role of supply shocks

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Assignment 1, Macro-Economics

Consider the case of 1970’s oil price increase. The regulation of supplies led to a supply
shock which led to increase in the prices of oil as well as in the levels of inflation. The period
is also characterized by high rate of unemployment. This dual increase causes the short run
Phillips curve to shift to right. Here the policy makers have an unfavourable trade-off
between inflation and rate of unemployment. The policymakers should either accept high
inflation rate for fixed unemployment rate or a higher unemployment rate for each inflation
rate. In case they reduce the aggregate demand to lower the inflation, they further risk higher
unemployment. If they increase aggregate demand to reduce employment, inflation increases.

The cost of reducing inflation

One of the methods that central banks can employ is disinflation – reduction in the rate of
inflation.

Figure 5: cost of reducing inflation

By checking the money supply, aggregate demand decreases which in turn reduces output and
increase unemployment. This movement is shown as movement from point A to point B. However,
expected inflation falls and the SRPC shifts downward and economy moves from point B to C.
Reduction in inflation would thus result in unemployment along with declined output. Slope of the
SRPC indicates the quantum of reduction in output and denotes the rate at which people adjust their
expectations of inflation.

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Assignment 1, Macro-Economics

Opposite happened in the late 1990s, the economic liberation led to the rise in wages, leading to high
demand and ultimately to high inflation. This inflation was curtailed by increasing productivity
through increase in efficiency and technological advancement.

We can conclude that before Friedman’s approach to Phillips Curve, the main focus was output-
unemployment trade-off. Expectations were “caveat” to Samuelson-Solow analysis. However –
Freidman ‘s approach had expectations central to the theory. The long run outcomes are invariant to
the monetary policy. However – this long neutrality of the of monetary policy does allow for short run
fluctuations. They argued that the natural rate of unemployment is determined by the structural forces
of the labour market rather than the demand-side policies. (Mankiw, 2010)

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Assignment 1, Macro-Economics

B. Based on reference journal articles provide a modern critique of Phillip’s curve

model by commenting on the empirical performance of the same. What about its
applicability in Indian scenario? (max 1000 words).

The Phillips Curve established an inverse relationship between unemployment and inflation.
While it establishes a correlation, the causality between the unemployment and inflation is
yet not established. Unemployment may depend on many things and some the things that
unemployment depends on affect inflation.

Freidman and Phelps also contradicted on the Phillips Proposition by laying down the
expectation theory. They adjudged that the unemployment is inversely related to anticipated
inflation. They also established that the it is real wages instead of nominal wages, which
effect the unemployment and inflation in the short run. In the long run, the inflation is equal
to expected inflation while we only have expectation of inflation change in the short run.

Freidman’s work gives the relationship between unemployment and short run inflation; there
does not exist any relationship between unemployment and inflation in the long run as
Phillips curves breaks down when π  πe. Further, Freidman himself acknowledges the
likehood that “long run Phillips curve may exist in vertical, yet it could be emphatically
inclined with the expanding portion of expansion prompting expanding joblessness.”.
(Schwarzer, 2013)

Another critique of the Phillips Curve comes from the Monetarists. They have long argued
that there is no trade-off between unemployment and inflation in the long run as aggregate
supply in the long run is perfectly inelastic. They argue that the price expectations of workers
is based on the previous year index, they perceive the change in nominal wages as change in
their real wages. The real wages stay the same in case the inflation is caused by increase in
aggregate demand. If they realize that there has been no increase in their real wages, they no
longer tend to work longer hours and the production returns to its initial levels. Thus the
unemployment remain same while inflation rate is higher.(Phillips Curve - Economics Help,
n.d.)

Rational expectations are to be backed by sound evidence. Economists who believe in the
rational expectation theory do not maintain that people always make accurate predictions.
They do however maintain that the collective predictions of economic decision makers will
not be consistently wrong over the long term. This stems up from the Rational Expectation
Theory, originally proposed by John Muth in 1961. John Lucas produced his critiques of the

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Assignment 1, Macro-Economics

macroeconomic policies in 1970s, criticizing both Keynesian and Monetarists theories.

“People tend to anticipate the consequences of any change in the fiscal policy: they behave
rationally”. (Lucas, 1976). He questioned the ability of the econometric models used to
predict the effect the policy experiments. He argued that the econometric models were of
reduced form, i.e. based on adaptive expectations rather than rational expectations and hence
they cannot correctly predict the outcomes of the economic policy as well as the alternate
policy. He suggested policymakers to look into “Deep Parameters” and strive to predict the
actions of individuals conditional to the change in policy.

Applicability to Indian Scenario:

The views on the applicability to Indian varies highly. Initially the Phillips curve is found to be non-
existent for India. However – taking only the industrial sector, supply and policy shocks of oil crises,
droughts and liberalization shocks into account, and using crop year as base as opposed to fiscal year,
a Phillips curve for the Indian manufacturing sector emerges. (Paul et al., 2011)

Researchers have argued about the shape of the Phillips Curve Being horizontal to vertical. This
unclarity may be attributed to the absence of well define, reliable and long run time series data on
unemployment and wages. (“an Empirical Study of Phillips Curve in India,” 2012) suggests that there
is short run Phillips curve in India, as the expected inflation is significantly less than one and above
zero. It establishes that the wages and prices are not sticky and the tradeoff between prices and
unemployment exits. It also suggests that any policy aimed at rapid economic growth or recovery will
not result in rise in inflation. On the contrary, a lower growth rate or a slower recovery may induce
inflationary tendency in the economy.

(Behera et al., 2018) make use of consumer price inflation index instead of wholesale price index. It
also confirms the presence of conventional Phillips Curve. Excess demand lead to increase in inflation
and exchange rate movements were found to be have significant impact on inflation.

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Assignment 1, Macro-Economics

References:

an Empirical Study of Phillips Curve in India. (2012). International Journal of Economics and
Research, 03(04), 10–25.

Behera, H., Wahi, G., & Kapur, M. (2018). Phillips curve relationship in an emerging economy:
Evidence from India. Economic Analysis and Policy, 59, 116–126.
https://doi.org/10.1016/j.eap.2018.06.001

Lucas, R. E. (1976). Econometric policy evaluation: A critique. In Carnegie-Rochester Confer. Series

on Public Policy (Vol. 1, Issue C, pp. 19–46). https://doi.org/10.1016/S0167-2231(76)80003-6

Mankiw, N. G. (2010). Macroeconomics, 7th Edition.

Motyovszki, G. (2013). The Evolution of Phillips Curve Concepts and Their Implications. Central
European University.

Paul, B. P., Zurich, E. T. H., Sturm, J., Gordon, R. J., Benati, L., ‫ ع‬.‫ ا‬,‫ربه‬., Behera, H., Wahi, G.,
Kapur, M., ‫ ف‬.‫ ص‬,‫سعید‬., Mazumder, S., Motyovszki, G., & Schwarzer, J. A. (2011). In search of
the Phillips curve for India. Journal of Asian Economics, 0(309), 359–388.
https://doi.org/10.1111/j.1468-0335.2009.00815.x

Phillips Curve - Economics Help. (n.d.). Retrieved May 15, 2020, from
https://www.economicshelp.org/blog/1364/economics/phillips-curve-explained/

Schwarzer, J. A. (2013). Samuelson and Solow on the Phillips Curve and the “Menu of Choice”: A
RetrospectiveUne rétrospective sur Samuelson et Solow à propos de la courbe de Phillips et du
« menu of choice ». OEconomia, 3–3, 359–388. https://doi.org/10.4000/oeconomia.138

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