Essential Economics: Phillips Curve: Unemployment & Inflation
The Phillips Curve: Unemployment and Inflation
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Students should understand both the short run and the long run Phillips Curves and be able to discuss their implications for economic policy
The Phillips Curve suggests a short-term trade-off between the rate of unemployment and the rate of inflation.
What might there be a trade-off?
The labour market
As unemployment falls, labour shortages may occur in industries where skilled labour is in short supply. This puts pressure on wages to rise, and since wages are usually a high % of costs, prices may rise.
Other factor markets
Cost-push inflation can come from rising demand for commodities such as oil, copper and manufactured goods such as steel, concrete and glass. This increases inflationary pressures in the economy.
Product market
Rising demand and output can lead to suppliers raising prices in order to widen their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand.
Explaining the Phillips Curve concept using AD-AS and the output gap
In the next diagram, we see an outward shift of the AD curve. This creates a positive output gap. Excess demand in product markets and factor markets causes a rise in production costs and this leads to an inward shift in short run aggregate supply. The fall in supply takes the economy towards potential output but at a higher price level.
We could equally use a diagram that uses a non-linear SRAS curve to demonstrate the argument. The next diagram shows the original short-run Phillips Curve and the trade-off between unemployment and inflation
Friedman and the Expectations-Augmented Phillips Curve
The original Phillips Curve idea was subjected to fierce criticism from the Monetarist school among them the American economist Milton Friedman. Friedman accepted that the short run Phillips Curve existed – but that in the long run, it was vertical and that there was no trade-off between unemployment and inflation.
He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused for example by a temporary boost to aggregate demand caused by a large monetary expansion and this had the effect of driving inflationary expectations higher, then this would cause an upward shift in the short run Phillips Curve.
The Monetarist view is that attempts to boost AD artificially to achieve faster growth and lower unemployment have only a temporary effect on output and unemployment. Friedman argued that a government could not permanently drive unemployment down below the NAIRU – the result would be higher inflation which in turn would bring about a return to higher unemployment but with inflationary expectations increased along the way.
Friedman introduced the idea of adaptive expectations – if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods. And they (or the trades unions who represent them) may then incorporate these changing expectations into their pay bargaining. Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and further upward pressure on the market prices of many different goods and services.
This is illustrated in the next diagram – inflation expectations are higher for SPRC2 than they are for SRPC1. The result may be that higher unemployment is required to keep inflation at a certain target level.
The Monetarist school believes that inflation is best controlled through control of money and credit. Credible policies can reduce inflation expectations – causing a shift in the short run Phillips Curve.
An inward shift in the long run Phillips Curve might be brought about by supply-side improvements to the economy – and in particular a reduction in the natural rate of unemployment. For example reforms might be successful in reducing frictional and structural unemployment – perhaps because of improved incentives to find work or gains in the human capital of the workforce that improves the occupational mobility of labour.
Factors that might explain the improved trade-off
The labour market - A more flexible labour market has increased the size of the labour supply and a reduction in trade union power has reduced the collective bargaining power of many workers. Falling long-term unemployment is a sign of a reduction in structural unemployment. We can be pretty certain that the NAIRU has come down. Although the NAIRU is not something we can observe and measure directly, it is estimated that the NAIRU has fallen from 10% of the labour force in 1992 to around 5% in the last few years.
The effect of inflation targets : The use of inflation targets which were introduced in1992 has helped to reduce inflation expectations and has helped to embed low-inflation in the British economy.
Low inflation in the global economy : External economic factors are important too! For a decade or more, cost and price inflation in many parts of the global economy has been on a downward path. Indeed the buzz word has been the threat of deflation in many developed countries. The rapid advance of globalization has increased the intensity of competition between nations and reduced the prices of many imported products. It is leading to a large rise in the global supply of many manufactured products.
Technological change and innovation has raised productivity and cut production costs across many different industries and sectors.
Why does a change in the Phillips Curve and the NAIRU matter?
Firstly a reduction in the NAIRU will have implications for the setting of interest rates by the Monetary Policy Committee. If they believe that the labour market can operate with a lower rate of unemployment without the economy risking a big rise in inflation, then the Bank of England may be prepared to run their monetary policy with a lower rate of interest for longer. This affects the growth of aggregate demand.
Secondly the trade-off between unemployment and inflation affects forecasts for how fast the economy can comfortably grow over the medium term. This information is a vital for the government when it is deciding on its key fiscal policy decisions. For example how much they can afford to spend on the major public services education, health, transport. Forecast growth affects their expected tax revenues which together with government spending plans then determine how much the government may have to borrow (the budget deficit).
| Business Objectives |
| Causes of Unemployment |
| Current Account Deficits |
| Economies of Scale & Scope |
| Globilisation & the UK |
| Manufacturing Industry in the UK |
| Phillips Curve |
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