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The Fed opted for the latter which led to a deep recession in the United States. Unemployment peaked above 10 percent in the early However, in the long run about six years after the recession , the economy had 3 to 4 percent inflation and was back to the natural rate of unemployment.


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The overall point is that a leftward shift in the Aggregate Supply curve does not move the economy along the short-run Phillips curve, but it moves the economy to a point that is northeast of its present state. If inflation expectations increase, the Phillips curve shifts upward. Of course, a positive supply shock can shift the Phillips curve down as inflation expectations fall.


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Once either of these things happens however, the policy makers are still faced with the same short-run tradeoff between inflation and unemployment. Another important factor explaining the odd behavior of the Phillips curve in the s is labor productivity, or output per labor hour. See Chapter 18, Economic Growth and Productivity. Recall that one reason for the short-run trade-off between inflation and unemployment is that when unemployment declines, wage pressures increase, driving up prices.

If productivity growth is high, however, firms can pay workers higher wages and still keep price increases modest becuase those workers are more productive. Productivity did begin to increase in the mids, and it has remained high through The surge in productivity is perhaps the key reason why wages and, hence, prices have not risen with the decline in unempoyment rates in the s. Similar to the s, many economists are seriously questioning the usefulness of even the modified inflation-expectations version of the Phillips curve. The events of the s indicate that, at the very least, the Phillips curve is not a reliable tool to forecast inflation.

Indeed, some economists are discounting the supposed short-run relationship between inflation and unemployment altogether, arguing that the relationship is too volatile to be a reliable guide. No new consensus has emerged as of yet. Although many economists agree that the forecasting power of the Phillips curve is limited at best, they continue to believe that the Phillips curve does a fairly good job at explaining economic behavior after the fact.

The Phillips curve illustrates the inverse relationship between inflation and unemployment. Useful Web Resources The Phillips curve is a graph illustrating the relationship between inflation and the unemployment rate. The long-run Phillips curve is vertical, suggesting that there is no tradeoff between unemployment and inflation. The Long-Run Phillips Curve Most economists now agree that in the long run there is no tradeoff between inflation and unemployment.

Any factor that shifts the Aggregate Demand curve moves the economy along the short-run Phillips curve. Suppose that the Aggregate Demand curve shifts to the right for any reason, say the result of expansionary fiscal or monetary policy. In the Phillips curve plotted in the right-hand figure, the higher price level corresponds with higher inflation, and the higher level of output means that more people are working, so unemployment falls.

The economy moves along the Phillips curve in the right-hand chart from point A to point B. The Role of Expectations The short-run tradeoff between inflation and unemployment is thought to work because people have an idea of what inflation expectations are going to be, and those expectations change slowly. Is the Phillips Curve Dead? Despite being reconstructed in the s, the Phillips curve threw economists for a loop again in the s. During much of the s, the Phillips curve relationship was suspiciously absent, as the figure titled "Phillips Curve, to " illustrates.

The economy's rate of unemployment fell, for example, from 7. Despite this decline, inflation did not rise much. In fact, in and inflation fell even further relative to previous years. Economists are not exactly sure why this happened, although lower oil and food costs played a significant role. Useful Web Resources Can the Phillips curve help forecast inflation? It was also generally believed that economies faced either inflation or unemployment, but not together - and whichever existed would dictate which macro-economic policy objective to pursue at any given time.

In addition, the accepted wisdom was that it was possible to target one objective, without having a negative effect on the other. Phillips analysed annual wage inflation and unemployment rates in the UK for the period — , and then plotted them on a scatter diagram. The data appeared to demonstrate an inverse and stable relationship between wage inflation and unemployment.

Phillips Curve | Economics Help

Later economists substituted price inflation for wage inflation and the Phillips curve was born. When economists from other countries undertook similar research, they also found very similar curves for their own economies. The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. It quickly became accepted that policy-makers could exploit the trade off between unemployment and inflation - a little more unemployment meant a little less inflation.

During the s and 70s, it was common practice for governments around the world to select a rate of inflation they wished to achieve, and then expand or contract the economy to obtain this target rate. This policy became known as stop-go , and relied strongly on fiscal policy to create the expansions and contractions required. By the mid s, it appeared that the Phillips Curve trade off no longer existed - there no longer seemed a stable pattern. The stable relationship between unemployment and inflation appeared to have broken down.

Short Run Phillips Curve

It was possible to have a number of inflation rates for any given unemployment rate. American economists Friedman and Phelps offered one explanation - namely that there is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve , which exists at the natural rate of unemployment NRU. Indeed, in the long-run, there is no trade-off between unemployment and inflation. Although there are disagreements between new-Classical economists and monetarists , the general line of argument about the breakdown of the Phillips curve runs as follows. Having more bargaining power, workers bid-up their nominal wages.

Expectations and the Phillips Curve : According to adaptive expectations theory, policies designed to lower unemployment will move the economy from point A through point B, a transition period when unemployment is temporarily lowered at the cost of higher inflation. However, eventually, the economy will move back to the natural rate of unemployment at point C, which produces a net effect of only increasing the inflation rate.

According to rational expectations theory, policies designed to lower unemployment will move the economy directly from point A to point C. The transition at point B does not exist as workers are able to anticipate increased inflation and adjust their wage demands accordingly.

Further Reading

Now assume that the government wants to lower the unemployment rate. To do so, it engages in expansionary economic activities and increases aggregate demand. As aggregate demand increases, inflation increases. Because of the higher inflation, the real wages workers receive have decreased. Consequently, employers hire more workers to produce more output, lowering the unemployment rate and increasing real GDP.

On, the economy moves from point A to point B. However, workers eventually realize that inflation has grown faster than expected, their nominal wages have not kept pace, and their real wages have been diminished.

Phillips curve

As labor costs increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the economy moves from point B to point C. This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself to the natural rate of unemployment with higher inflation.

The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will be very close to the market equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will take this past information and current information, such as the current inflation rate and current economic policies, to predict future inflation rates. As an example of how this applies to the Phillips curve, consider again. However, under rational expectations theory, workers are intelligent and fully aware of past and present economic variables and change their expectations accordingly.


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They will be able to anticipate increases in aggregate demand and the accompanying increases in inflation. As such, they will raise their nominal wage demands to match the forecasted inflation, and they will not have an adjustment period when their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point A to point C, without transitioning to point B. In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically undermined by rational workers.

They can act rationally to protect their interests, which cancels out the intended economic policy effects. Efforts to lower unemployment only raise inflation. Aggregate supply shocks, such as increases in the costs of resources, can cause the Phillips curve to shift. The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run, there is no trade-off. Stagflation caused by a aggregate supply shock. The increased oil prices represented greatly increased resource prices for other goods, which decreased aggregate supply and shifted the curve to the left.

As aggregate supply decreased, real GDP output decreased, which increased unemployment, and price level increased; in other words, the shift in aggregate supply created cost-push inflation.

The Phillips Curve Trade-Off

Aggregate Supply Shock : In this example of a negative supply shock, aggregate supply decreases and shifts to the left. The resulting decrease in output and increase in inflation can cause the situation known as stagflation. The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment and high inflation. At the time, the dominant school of economic thought believed inflation and unemployment to be mutually exclusive; it was not possible to have high levels of both within an economy.

Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there were now corresponding levels of inflation that were higher than the Phillips curve predicted; the Phillips curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable trade-off between unemployment and inflation.

Disinflation is a decline in the rate of inflation, and can be caused by declines in the money supply or recessions in the business cycle. Inflation is the persistent rise in the general price level of goods and services. Disinflation is a decline in the rate of inflation; it is a slowdown in the rise in price level.

The economy is experiencing disinflation because inflation did not increase as quickly in Year 2 as it did in Year 1, but the general price level is still rising. Disinflation is not to be confused with deflation, which is a decrease in the general price level. Disinflation can be caused by decreases in the supply of money available in an economy. It can also be caused by contractions in the business cycle, otherwise known as recessions. The Phillips curve can illustrate this last point more closely.

Consider an economy initially at point A on the long-run Phillips curve in. Suppose that during a recession, the rate that aggregate demand increases relative to increases in aggregate supply declines. This reduces price levels, which diminishes supplier profits. As profits decline, employers lay off employees, and unemployment rises, which moves the economy from point A to point B on the graph. Eventually, though, firms and workers adjust their inflation expectations, and firms experience profits once again.

As profits increase, employment also increases, returning the unemployment rate to the natural rate as the economy moves from point B to point C. The expected rate of inflation has also decreased due to different inflation expectations, resulting in a shift of the short-run Phillips curve.

Principles of Economics/Philips

Disinflation : Disinflation can be illustrated as movements along the short-run and long-run Phillips curves. To illustrate the differences between inflation, deflation, and disinflation, consider the following example. Assume the following annual price levels as compared to the prices in year As the economy moves through Year 1 to Year 4, there is a continued growth in the price level.

This is an example of inflation; the price level is continually rising. However, between Year 2 and Year 4, the rise in price levels slows down. Between Year 2 and Year 3, the price level only increases by two percentage points, which is lower than the four percentage point increase between Years 1 and 2. The trend continues between Years 3 and 4, where there is only a one percentage point increase. This is an example of disinflation; the overall price level is rising, but it is doing so at a slower rate.

Between Years 4 and 5, the price level does not increase, but decreases by two percentage points. This is an example of deflation; the price rise of previous years has reversed itself. Skip to main content. Inflation and Unemployment. Search for:.