In what follows we first explain the rationale underlying the Phillips curve, that is, how the inverse relationship between inflation and unemployment can be. Known after the British economist A.W. Phillips who first identified it, it expresses an inverse relationship between the rate of unemployment and the rate of. The relationship between inflation and unemployment has traditionally been an inverse correlation. However, this relationship is more.
In a recession, there will be greater price competition. Therefore, the lower output will definitely reduce demand-pull inflation in the economy. Cost-Push Inflation — a worse trade off To complicate the issue, inflation can also be caused by cost-push factors.
For example, an increase in oil prices could cause a rise in inflation and a rise in unemployment. This is because higher oil prices push up costs and reduce disposable income. Therefore, due to cost push factors, the relationship between inflation and unemployment can break down. However, cost-push factors tend to be temporary. There still remains an underlying relationship between unemployment and inflation.
Given the level of money wage rate which was fixed on the basis that the 5 per cent rate of inflation would continue to occur, the higher price level than expected would raise the profits of the firms which will induce the firms to increase their output and employ more labour. As a result of the increase in aggregate demand resulting in a higher rate of inflation and more output and employment, the economy will move to point A1 on the short- run Phillips curve SPC1 in Figure It may be noted from Figure Thus, this is in conformity with the concept of Phillips curve explained earlier.
The Phillips Curve: Relation between Unemployment and Inflation
However, the advocates of natural rate theory interpret it in a slightly different way. They think that lower rate of unemployment achieved is only a temporary phenomenon. They think when the actual rate of inflation exceeds the one that is expected, unemployment rate will fall below the natural rate only in the short run. In the long run, the natural rate of unemployment will be restored. This brings us to the concept of long-run Phillips curve, which Friedman and other natural rate theorists have put forward.
According to them, the economy will not remain in a stable equilibrium position at A1. This is because the workers will realize that due to the higher rate of inflation than the expected one, their real wages and incomes have fallen.
The workers will therefore demand higher nominal wages to restore their real income. But as nominal wages rise to compensate for the higher rate of inflation than expected, profits of business firms will fall to their earlier levels. This reduction in their profit implies that the original motivation that prompted them to expand output and increase employment resulting in lower unemployment rate will no longer be there.
Inflation – Unemployment Relationship | Economics Help
That is, with the increase is nominal wages in Figure Further, at point B0, and with the actual present rate of inflation equal to 7 per cent, the workers will now expect this 7 per cent inflation rate to continue in future. It therefore follows, according to Friedman and other natural rate theorists, that the movement along a Phillips curve SPC is only a temporary or short-run phenomenon.The Phillips Curve and Keynesian La-La Land: The Alleged Relationship Between Unemployment and...
In the long when nominal wages are fully adjusted to the changes in the inflation rate and consequently unemployment rate comes back to its natural level, a new short-run Phillips curve is formed at the higher expected rate of inflation. However, the above process of reduction in unemployment rate and then its returning to the natural level may continue further.
The Government may misjudge the situation and think that 7 per cent rate of inflation is too high and adopt expansionary fiscal and monetary policies to increase aggregate demand and thereby to expand the level of employment.
With the new increase in aggregate demand, the price level will rise further with nominal wages lagging behind in the short-run. As a result, profits of business firms will increase and they will expand output and employment causing the reduction in rate of unemployment and rise in the inflation rate.
After some time, the workers will recognize the fall in their real wages and press for higher normal wages to compensate for the higher rate of inflation than expected. That is, in Figure The process may be repeated again with the result that while in the short run, the unemployment rate falls below the natural rate, in the long run it returns to its natural rate.
But throughout this process the inflation rate continuously goes on rising. On joining points such as A0, B0, C0 corresponding to the given natural rate of unemployment we get a vertical long-run Phillips curve LPC in Figure It is important to remember that adaptive expectations theory has also been applied to explain the reverse process of disinflation, that is, fall in the rate of inflation as well as inflation itself.
Suppose in Figure Now, if a decline in aggregate demand occurs, say as a result of contraction of money supply by the Central Bank of a country, this will reduce inflation rate below the 9 per cent expected rate. As a result, profits of business firms will decline because the prices will be falling more rapidly than wages. The decline in profits will cause the firms to reduce employment and consequently unemployment rate will rise.
Eventually, firms and workers will adjust their expectations and the unemployment rate will return to the natural rate. The process will be repeated and the economy in the long run will slide down along the vertical long-run Phillips curve showing falling rate of inflation at the given natural rate of unemployment. It follows from above that according to adaptive expectations theory any rate of inflation can occur in the long run with the natural rate of unemployment.
In the end we explain the viewpoint about inflation and unemployment put forward by Rational Expectations Theory which is the cornerstone of recently developed macroeconomic theory, popularly called new classical macroeconomics.
This lag in the adjustment of nominal wages to the price level brings about rise in business profits which induces the firms to expand output and employment in the short run and leads to the reduction in unemployment rate below the natural rate. According to the rational expectations theory, which is another version of natural unemployment rate theory, there is no lag in the adjustment of nominal wages consequent to the rise in price level. The advocates of this theory further argue that nominal wages are quickly adjusted to any expected changes in the price level so that there does not exist Phillips curve showing trade-off between rates of inflation and unemployment.
According to them, as a result of increase in aggregate demand, there is no reduction in unemployment rate. The rate of inflation resulting from increase in aggregate demand is fully and correctly anticipated by workers and business firms and get completely and quickly incorporated into the wage agreements resulting in higher prices of products.
Thus, it is the price level that rises, the level of real output and employment remaining unchanged at the natural level. Hence, aggregate supply curve according to the rational expectations theory is a vertical straight line at the full-employment level.
Rational expectations theory rests on two basic elements. The second premise of rational expectations theory is that, like the classical economists, it assumes that all product and factor markets are highly competitive. As a result, wages and product prices are highly flexible and therefore can quickly change upward and downward.
Indeed, the rational expectations theory considers that new information is quickly assimilated i. In this OQ is the level of real national output corresponding to the full employment of labour with a given natural rate of unemployment. AS is aggregate supply curve at OQ level of real national output.
To begin with, AD1 is the aggregate demand curve which intersects the aggregate supply curve AS at point A and determines price level equal to P1. Suppose Government adopts an expansionary monetary policy to increase output and employment.
As a consequence, aggregate demand curve shifts upward to the new position AD2. According to rational expectations theory, people i. Accordingly, workers would press for higher wages and get it granted, businessmen would raise the prices of their products, lenders would hike their rates of interest.
All these increases would take place immediately.
It is the unemployment rate below which the inflation rate increases, and above which the inflation rate decreases. At this rate, there is neither a tendency for the inflation rate to increase or decrease. Thus the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment.
This natural or equilibrium unemployment rate is not fixed for all times. Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy. These may be minimum wage laws, inadequate employment information, deficiencies in manpower training, costs of labour mobility, and other market imperfections.
But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctly forecasts inflation and can adjust wages to the forecast. Suppose the economy is experiencing a mild rate of inflation of 2 per cent and a natural rate of unemployment N of 2 per cent.
At point A on the short-run Phillips curve SPC1 in Figure 7, people expect this rate of inflation to continue in the future. Now assume that the government adopts a monetary-fiscal programme to raise aggregate demand in order to lower unemployment from 3 to 2 per cent.
The increase in aggregate demand will raise the rate of inflation to 4 per cent consistent with the unemployment rate of 2 per cent. When the actual inflation rate 4 per cent is greater than the expected inflation rate 2 per centthe economy moves from point A to B along the SPC1 curve, and the unemployment rate temporarily falls to 2 per cent. This is achieved because the labour has been deceived.
Inflation and Unemployment: Philips Curve and Rational Expectations Theory
It expected the inflation rate of 2 per cent and based their wage demands on this rate. But the workers eventually begin to realise that the actual rate of inflation is 4 per cent which now becomes their expected rate of inflation. Now workers demand increase in money wages to meet the higher expected rate of inflation of 4 per cent.
They demand higher wages because they consider the present money wages to be inadequate in real terms. In other words, they want to keep up with higher prices and to eliminate fall in real wages. If the government is determined to maintain the level of unemployment at 2 per cent, it can do so only at the cost of higher rates of inflation.
From point C, unemployment once again can be reduced to 2 per cent via increase in aggregate demand along the SCP2 curve until we arrive at point D. With 2 per cent unemployment and 6 per cent inflation at point D, the expected rate of inflation for workers is 4 per cent. As soon as they adjust their expectations to the new situation of 6 per cent inflation, the short-run Phillips curve shifts up again to SPC3 and the unemployment will rise back to its natural level of 3 per cent at point E.
On this curve, there is no trade-off between unemployment and inflation.
The Phillips Curve: Relation between Unemployment and Inflation
Rather, any one of several rates of inflation at points A, C and E is compatible with the natural unemployment rate of 3 per cent. But this is only possible temporarily so long as workers overestimate or underestimate the inflation rate.
In the long-run, the economy is bound to establish at the natural unemployment rate. This is because inflationary expectations are revised according to what has happened to inflation in the past. So when the actual rate of inflation, say, rises to 4 per cent in Figure 7, workers continue to expect 2 per cent inflation for a while and only in the long run they revise their expectations upwards towards 4 per cent.
Since they adapt themselves to the expectations, it is called the adaptive expections hypothesis. According to this hypothesis, the expected rate of inflation always lags behind the actual rate.
But if the actual rate remains constant the expected rate would ultimately become equal to it. This leads to the conclusion that a short run trade-off exists between unemployment and inflation, but there is no long run trade-off between the two unless a continuously rising inflation rate is tolerated.
The accelerationist hypothesis of Friedman has been criticised on the following grounds: The vertical long-run Phillips curve relates to the steady rate of inflation. But this is not a correct view because the economy is always passing through a series of disequilibrium positions with little tendency to approach a steady state. In such a situation, expectations may be disappointed year after year.