4.8. The Phillips Curve Flashcards
1
Q
The Phillips Curve meaning
A
shows the trade off between inflation and unemployment
2
Q
The Phillips Curve diagram (DRAW DIAGRAM)
A
- y-axis = inflation
- x-axis = unemployment
- downwards sloping curve –> to under x-axis
3
Q
The Phillips Curve Background
A
- A W Phillips (1958), LSE.
- Based on UK unemployment rates and wage inflation 1860-1957.
- Shows inverse relationship between (wage) inflation and unemployment.
4
Q
Explaining the Phillips Curve (DRAW DIAGRAM)
A
- Economy has high unemployment (A).
- Fiscal stimulus increases AD.
- Increases the demand for labour.
- Reduces the availability of unemployed workers.
- Workers have greater bargaining power to increase their nominal wages.
- Firms are forced to raise nominal wages as they compete for unemployed workers.
- Wage costs rise.
- Firms pass on higher costs by increasing prices.
- Inflation rate rises (B).
- Lower unemployment, higher inflation.
5
Q
Phillips Curve as a part of Keynesian economics
A
- During the 1960s/70s, policy makers believed they could exploit the trade off.
- Governments could select an inflation rate they wished to achieve and used expansionary / contractionary fiscal policy to achieve the target inflation rate (known as “stop-go”).
- Phillips curve is a part of Keynesian economics.
- Keynesian theory implied that during a recession, when GDP was below potential and unemployment was high, inflationary pressures would be low.
- Alternatively, when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation.
6
Q
Explaining the Phillips Curve using AD / AS analysis (DRAW DIAGRAM)
A
- Expansionary FP increases AD.
- This causes higher real GDP.
- Firms employ more workers, which reduces unemployment.
- As the economy approaches full capacity, the price level rises (i.e. inflation rates increase) due to a lack of labour resources.
7
Q
Shifts in the Phillips curve (SRPC)
A
Monetarists believe there are a number of different short run Phillips curves (SRPC) that exist at the natural rate of unemployment (NRU).
Two causes of outward shift of SRPC:
1) Higher inflation expectations.
2) Supply shocks.
8
Q
Long-run Phillips curve (DRAW DIAGRAM)
A
- However, workers do not suffer from “money illusion”.
- They realise price inflation has eroded their nominal wage increase.
- Workers will raise their inflationary expectations.
- Some workers demand a real wage increase.
- Some workers withdraw from the labour market.
- Costs of production rise.
- Output drops and unemployment rises.
- Unemployment returns to NRU but with higher inflation built in.
- Move from B to C.
- LRPC exists at the natural rate of unemployment (NRU).
- Monetarists believe that there is no trade-off between inflation and unemployment in the long run.
9
Q
Long-run Phillips curve using AD / AS analysis (DRAW DIAGRAM)
A
- Long run Phillips curve can also be demonstrated using AD/AS analysis:
- Expansionary FP increases AD.
- Move from A to B.
- GDP rises, unemployment falls.
- Higher PL causes higher wage demands.
- Higher costs decrease SRAS.
- Move from B to C.
- Economy moves back to LRAS, unemployment returns to NRU but with a higher price level.
10
Q
Shifts in the Long-run Philips curve
A
- Shift outwards due to increased NRU (more structural / frictional unemployment) and vice versa
- NRU is made up of structural and frictional unemployment.
- Supply-side policies (e.g. training and education) help to reduce structural unemployment.
- Supply-side policies (e.g. better job information) help to reduce frictional unemployment.
- In the long run, only supply-side policies will help to reduce NRU.
11
Q
Philips curve conclusions
A
- In the short run, there can be a trade-off between unemployment and inflation. Expansionary FP and MP can be used to reduce unemployment but it is likely to lead to inflation.
- In the long run, there is no trade-off between unemployment and inflation. Supply side policies need to be used to reduce the natural rate of unemployment (structural and frictional).
