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International Finance
Economy

Phillips Curve Model

Phillips observed that one stable curve represents the trade-off between inflation and unemployment and they are inversely related. In other words, if unemployment decreases, inflation will increase and vice versa. 16th October 2013 The Phillips curve suggests there is an inverse relationship between inflation and unemployment, it is an ideal guide for policy makers (central banks) to have a choice between prioritising inflation and unemployment...

Phillips observed that one stable curve represents the trade-off between inflation and unemployment and they are inversely related. In other words, if unemployment decreases, inflation will increase and vice versa.

16th October 2013

The Phillips curve suggests there is an inverse relationship between inflation and unemployment, it is an ideal guide for policy makers (central banks) to have a choice between prioritising inflation and unemployment to stabilise the economy. New Zealand -born economist A.W Phillips put forward this theory in 1958 after gathering data of unemployment and changes in wage levels in the UK from 1861 to 1957, during the 1950’s and 60’s Phillips Curve Analysis- suggested there was a trade off and policy makers could use demand management (fiscal and monetary policies) to try and influence the rate of growth and inflation. For example: If unemployment was high and inflation low, policy makers could stimulate aggregate demand, but cause a higher rate of inflation. Phillips observed that one stable curve represents the trade-off between inflation and unemployment and they are inversely related. In other words, if unemployment decreases, inflation will increase and vice versa. For example, after the economy has just been in recession, the unemployment rate will be fairly high, once the economy has just begun to recover, the aggregate demand will increase therefore leading to an increase in employment. In the beginning there will be pressure to increase wages. However, as the economy grows faster and more people are employed, wages will start rising slowly-this will increase the firm’s cost of production and the high costs are usually passed to the customer in the form of higher prices. Therefore a decrease in unemployment will lead to an increase in inflation and vice versa.

Fiscal Policy and the Phillips Curve

After 1945, fiscal demand management became the general tool for managing the trade cycle. The consensus was policymakers should stimulate aggregate demand (AD) when faced with recession and unemployment, and constrain when experiencing inflation. It was also generally believed that economies faced either inflation or unemployment, but not together- and either inflation or unemployment would dictate the macroeconomic policy objective to pursue at any given time. In addition, policymakers thought it was possible to target one objective, without having a negative effect on the other. Phillips analyzed annual wage inflation and unemployment rates in the UK for the period 1860 -1957 and plotted them on a scatter diagram. Economists later substituted price inflation for wage inflation and the Phillips curve was born. When economists from other countries undertook similar research, they also found similar curves for their own economies. Phillips showed that unemployment and inflation showed an inverse relationship: inflation in a country went up as more people got employed and inflation fell as unemployment reached its peak

In the imaginary Phillips curve depicted above, the inflation rate is represented on the vertical axis in units of percent per year. The unemployment rate is represented on the horizontal axis in units of percent. The curve shows the levels of inflation and unemployment that tend to match together approximately, based on historical data. In this curve, an unemployment rate of 7 percent seems to correspond to an inflation rate of 4 percent while an unemployment rate of 2 percent corresponds to an inflation rate of 6 percent. As depicted in the curve, when unemployment falls, inflation increases. The Phillips curve can be represented mathematically by using the following formula:

Inflation = [(expected inflation) – B] x [(cyclical unemployment rate) +error]

Criticisms

The major criticism levied against the Phillips curve and other macroeconomic models of the 1960’s and 1970’s was that they were not truly structural. Milton Friedman an American economist criticized it saying that there was no trade off between unemployment and inflation in the longer run. Friedman argued that each short run Phillips curve was drawn on the assumption of a given expected rate of inflation. So if there was an increase in inflation  caused for example by a temporary boost to aggregate demand caused by a large monetary expansion, this had the effect of driving inflationary expectations higher and could cause an upward shift in the short run Phillips curve. Friedman’s view was that governments could not permanently attempt to drive unemployment down the NAIRU (Non Accelerating Inflation Rate of Unemployment) – the result would be high rates of inflation

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