The Phillips Curve – Unemployment and Inflation

The Phillips Curve shows a trade-off between inflation and unemployment. A demand-side policy to reduce unemployment could conflict with price stability

• As the rate of unemployment falls, labour shortages may cause an increase in wage inflation leading to higher unit labour costs
• When an economy is booming, so does the derived demand for and prices of components and raw materials – this leads to higher costs
• Rising demand and falling unemployment can lead to suppliers raising prices to increase their profit margins

Long run Phillips Curve

• Neo-classical economists believe that in the long output always returns to a long run equilibrium path
• They also argue that an economy will tend to revert to a level of output where unemployment returns to the natural rate of unemployment made up of frictional and structural U.
• The Long Run Phillips Curve is drawn as vertical i.e. it is assumed to be independent of the level of short run demand/output and the general price level

Inward Shift of the Long Run Phillips Curve

Successful supply-side policies help to:

1. Improve the occupational mobility of labour force
2. Attract more people into an active search for work
3. Reduce the problem of occupational immobility
4. Lift labour productivity

These policies can lead to a fall in the natural rate of unemployment (frictional + structural unemployment). This causes the long run Phillips Curve to shift to the left

Critical Evaluation on Conflicts between Macro Policies

1. Government priorities change: In the 1970s and 1980s inflation was seen as the biggest problem; unemployment was higher than now.
2. Objectives depend on a country’s stage of development. Emerging countries might target rapid growth and extreme poverty reduction and be prepared to accept a higher rate of inflation
3. Value judgement matter. Consider the debate over fiscal deficit reduction (Keynesians v Fiscal Conservatives); or critics of ultra-low interest rates and their effect on savers
4. Some objectives are sub-sets of others – e.g. export led growth improves the trade balance
5. Are some of the objectives conflicting in the short run but not in the LR – for example a tax cutting policy designed to attract inward FDI
6. External shocks can help relieve conflicts or make them worse
7. Nothing in macroeconomics happens in isolation. Most countries are deeply inter-connected.
8. A government may satisfice – i.e. be satisfied with reasonable outcomes for each objectives and tolerate some trade-offs