The Philips Curve Flashcards
Short run phillips curve
- shows that there is a trade off between unemployment and inflation
- shows that the reationship between the unemployment rate and the inflation rate is inversely proportional
- assumes a close relationship between changes in the wage rate and the rate of inflation
What does the short run phillips curve help policy makers decide?
- allows policy makers to decide which demand side policy to use and how effective they will be for the economy in the long run
What policy conflict does this create for governments?
- trade off between low and stable inflation and unemployment
What did Milton Friedman argue about expectations?
- workers formed their expectations of future inflation on the basis of past inflation
Adaptive expectations hypothesis
People form their expectations on the basis of previous and present inflation rates and change or adapt their expectation if and only when it turns out to be a different rate than the expected one
- important when evaluating the role of demand side policy in attempting to reduce the unemployment rate
What happens in the short term when there is a cut in income tax on the short run phillips curve?
(neoclassical point of view)
- when there is a cut in income tax, consumption increases, so AD increases, prices decrease from P2 to P1, which leads to a positive output gap
- in the short term, workers from A to B suffering from money illusion as basing their inflation expectation on the past price P1 but inflation is actually at P2
- workers are psychologically conditioned to think they are earning more, but in reality their real wages have not gone up
- now more productive and motivated
What happens in the long term when there is a cut in income tax on the short run phillips curve?
- Workers eventually realize that that they have lower purchasing power as they realized their nominal wage has not kept up with the inflation rate
- This stops the money illusion and workers start to bargain and demand hire wages
- Firms costs of production increases so SRAS shifts to the left as it is less profitable
- When workers adapt the expectations of the present inflation rate this leads to the srpc being shifted upwards
- Have returned to the same level of unemployment but with higher inflation rate
- Therefore demand side policies are ineffective as purely inflationary
Long Run Phillips Curve/NAIRU
- it is vertical meaning that there is no trade-off between unemployment and inflation
- in the long run unemployment always comes back to the same level
- this is called the natural non-accelerating inflation rate of unemployment (NAIRU)
Natural non accelerating inflation rate of unemployment (NAIRU)
The rate of unemployment at which inflation will not change or accelerate providing nothing is done to boost AD or unemployment
- it includes frictional, seasonal structural unemployment
Why is the NAIRU not zero?
They will always be frictional unemployment even in a boom
What do monetarists argue that the relationship of inflation and unemployment will be in the long run?
perfectly inelastic
How do monetarists argue the NAIRU can be reduced?
- don’t believe in the use of demand side policies as it is purely inflationary
- believe supply side policies should be used to get rid of unemployment
- investing in education and training
The impact of supply-side policies on the NAIRU
- increase in the quality and quantity of FOP which leads to the LRAS shifting to the right
- now better and more FOP so firms don’t have to spend more to acquires scarce resources, lowers COP and shifts the SRAS curve to the right so prices decrease
- Inflation rate decreases, leading to people revising their wage expectation downwards so the SRPC shifts downwards
- LRPC shifts to the left as the NAIRU decreases
- Output increases, unemployment decreases, inflation decreases
Usefulness of the Phillips curve for policy makers
1. Depends upon the extent of the inflation rate
- When inflation is always low and stable workers will not realise inflation changes and so will suffer from the money illusion for longer
- policy makers now know that workers won’t adapt their inflation expectation
- policymakers can get away with using demand side policy for longer making their SRPC more useful
2. Depends upon the relationship between wages and inflation
- the Phillips Curve suggests a strong correlation between inflation and wages so if inflation increases wages go up
- this isn’t the case now as wages don’t make up a majority firms COP due to a rise in technology reducing the need of workers
- the rise of zero contracts reduces the importance of wages in cost of production as firms can change the hours that staff work
- if we were part of the EU we would attract a lot of immigration in the UK which increases labor pool which puts downward pressure on the wage rate reducing its importance
3. Depends upon the extent to which expectations are rational
- in developing countries where the HDI score is very low literature rates very low meaning that they may not even know what inflation is
- will suffer from money illusion even longer
- this is useful for policy makers in developing countries as this makes demand side policies more useful as their inflation expectation wont adapt as far, making SRPC more useful
4. Depends on the rate of the Central Bank in managing expectations
- Bank of England in charge of keeping inflation between 1-3% so people likely to trust them as have a really good track record of meeting this target
- people won’t be as worried and are confident in the bank, so workers won’t bargain and demand for higher wages and won’t be adaptive with the expectations
- this means that they can use demand side policies and so the srpc is useful as people will remain on the srpc
Evaluating the factors of the Philips curve
- Workers are very likely to adapt their inflation expectations when inflation is high and volatile meaning they are more likely to notice it so instead the LRPC is more useful
- If the LRPC becomes more useful it suggests to policymakers that they need to use supply side policies instead
- In developed countries like the UK, there is no time lag meaning you don’t have to go from A to B to C you go straight from A to C as people are aware of inflation
- This is useful as it signifies policy makers that supplies that policies are more useful to decrease unemployment
- in the real world, inflation has been above the target for over two years now meaning people don’t trust the bank and they will adapt their expectations faster, this makes the LRPC more useful
