Policy conflicts: the Phillips curve

Question 1

What are 2 macroeconomic conflicts that could occur in the short term

Answer 1

1. growth objective conflicts unemployment objective when innovation causes structural unemployment
2. inflation objective conflicts unemployment objective (shown by Philips curve)

Question 2

Describe the short run Phillips curve

Answer 2

Inflation on y axis and unemployment on x axis with inversely proportional relationship between them (in the form k/x)

Question 3

What is the difference between shifted in and shifted out short run Phillips curves

Answer 3

Represent different inflationary expectations where shifted out means a higher inflationary expectation

Question 4

Explain how economy moves along the short run Phillips curve

Answer 4

1. Unemployment starts at NAIRU level
2. Imagine shift out in AD which causes positive output gap
3. Demand pull inflation and derived demand for labour increase
4. Workers see wages rise and frictionally unemployed workers shorten their job search so unemployment falls

Increase in inflation and decrease in unemployment means move up along the short run Phillips curve

Question 5

After moving along the short run Phillips curve, explain why the economy moves to a different short run Phillips curve with different inflationary expectations (point B to point C)

Answer 5

(Keeping example of inflation rose and unemployment fell)

1. In the long run people realise that the wages only went up due to inflation and they were suffering from money illusion, unemployment rate rises back to NAIRU level
2. This causes inflationary expectations to rise so operating on a new Phillips curve with the same inflation rate but with natural rate of unemployment

Question 6

Why is there no trade off between unemployment and inflation in the long run

Answer 6

The process (A to B to C) repeats again and in the long run will always end up at the NAIRU level, which is compatible with any inflation rate

This is why the long run Phillips curve is a vertical line at the NAIRU level

Question 7

What has been the recent trends with how the Phillips curve has changed within the UK

Answer 7

Become continuously lower and flatter in recent years showing that inflation is low and changes to unemployment aren’t affecting it much

Question 8

Why do economists think unemployment can now fall to lower levels without inflation rising quickly

Answer 8

1. More flexible labour markets reduce frictional and structural unemployment, so firms don’t have to incentivise workers with higher wages, which would lead to inflation
2. Firms have the option of outsourcing work for cheaper elsewhere due to globalisation so domestic workers have less bargaining power

Question 9

Why might lower unemployment not lead to higher inflation

Answer 9

1. With a large negative output gap a shift out in AD doesn’t cause inflation as LRAS is horizontal
2. The Phillips curve is getting flatter so unemployment can now fall to lower levels without inflation rising
3. Supply side policies can decrease NAIRU so shift long run Philips curve in and inflation doesn’t change
4. Positive supply side shocks reduce inflation and unemployment (benign deflation) and negative supply side shocks increase both (stagflation)