SEBI Gr A 2020

Economics
Phase
1&2
Inflation and Phillips curve

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Code: NABARD50
Background
▪ In Keynesian model,
▪ Increase in aggregate demand before the level of full employment → causes
increase in the level of output and employment with price level remaining
unchanged.

▪ It means that is no cost (in the form of rise in price level) has to be
incurred for raising the raising the level of output and reducing
unemployment.

▪ But, once the full employment is reached and aggregate supply curve
becomes vertical → Further increase in aggregate demand will only raise
the price level in the economy.

▪ Thus, in Keynesian model, inflation occurs in the economy only after full-
employment level of output has been attained.
▪ Thus there is no tradeoff and clash between inflation and
unemployment.
Inflation – Unemployment Trade-off : Phillips Curve
▪ A noted british economist, A.W. Phillips published an article in 1958 based on his
good deal of research using historical data from the U.K for about 100 years.
▪ He arrived at the conclusion that there is an inverse relationship between rate of
unemployment and rate of inflation.

This inverse relationship

implies a tradeoff
i.e.
▪ For reducing unemployment,
price in the form of higher rate
of inflation has to be paid.
▪ And, for reducing the rate of
inflation, price in terms of
higher rate of inflation has to
be borne.
Now, this trade-off presented a dilemma for the policy makers:

Should they choose a higher rate of inflation with lower unemployment

Or
A higher rate of unemployment with low inflation rate
 Keynesian explanation of Phillips curve
Keynes has assumed that aggregate
supply curve slopes upward.
What does it mean?
▪ It means that quantity supplied
increases when the price rises.

In Panel (A)
AD0 = Initial Demand curve
P0 = Initial Prices
Y0 = Initial Income level
a = Initial Equilibrium
Corresponding to equilibrium ‘a’… U3 is
the level of unemployment in Panel (b)
When demand increases to AD1
▪ New equilibrium will be at point ‘b’
▪ Prices will increases to P1 and Income level will increase to Y1
▪ Corresponding to equilibrium ‘b’… U2 is the level of unemployment in Panel (b) →
which is lesser than U3.
When demand further increases, AD3 will be the new demand curve.
▪ The new equilibrium will be at point ‘c’
▪ Prices will increase to P2 and Income level will increase to Y2.
▪ Corresponding to equilibrium ‘c’… U1 is the level of unemployment in
Panel (b) → which is lesser than U2.

So in Keynesian explanation,
▪ A higher rate of increase in aggregate demand will lead to higher
rate of rise in price level and Income.
▪ Higher Income means higher production which means lower level of
unemployment.
▪ This is what is represented by Phillips curve.

We can also conclude that Inflation and Unemployment has inverse

relationship.
Collapse of Phillips curve in the USA (1971-91)
▪ Phillips curve suggests that policy could have a lower
rate of unemployment if they could bear with higher
level of inflation.
▪ On the contrary, they could achieve a low rate of
inflation only if they were prepared to reconcile with a
higher rate of unemployment.

▪ But this could not hold true during the 70s and 80s
especially in the United states.

▪ Data from the two decades (1971-91) showed that

rates of both inflation and unemployment increased
in United states, which shows the absence of trade-
off.
▪ This phenomenon of high inflation and
unemployment at the same time, came to be known
as stagflation.
Now, what could be the cause of shift in Phillips curve?
There are two explanations for this:

▪ First, according to Keynesians, the

occurrence of higher rate inflation
along with the increase in
unemployment witnessed during the
seventies and eighties was due to the
adverse supply shock.

▪ This adverse supply shock was in the

form of fourfold increase in the prices
of oil and petroleum products
delivered to America.

Adverse supply shock giving rise to

stagflation and breakdown of Phillips
curve
 Natural Rate Hypothesis

▪ The second explanation of occurrence of stagflation was provided by Friedman.

▪ He challenged the concept of stable downward sloping Phillips curve.

▪ According to him, though there is a trade-off between rate of Inflation and

unemployment in the short run i.e there exists a short run downward sloping Phillips
curve.
▪ But it is not stable and it often shifts both leftward and rightward.

▪ According to him, there is no long-run stable trade-off between rates of inflation and
unemployment.
▪ In long-run, economy comes back to be in stable equilibrium at the natural rate of
unemployment.
▪ Therefore, the long-run Phillips curve is a vertical straight line.

▪ This theory of Friedman is known as ‘Natural Rate Hypothesis’ or ‘Adaptive

Expectations theory’.
What is Natural rate of unemployment?
▪ It is the rate at which in the labour market, the current number of unemployed is
equal to the number of jobs available.
▪ These unemployed workers are not employed for the frictional and structural reasons.

What is Frictional unemployment?

▪ The unemployment which exists in any economy due to people being in the process of
moving from one job to another.
▪ It is time spent between jobs when a worker is searching for a job or transferring from
one job to another.

What is Structural unemployment?

▪ Structural unemployment is a form of involuntary unemployment caused by a
mismatch between the skills that workers in the economy can offer, and the skills
demanded of workers by employers.
▪ It is often brought about by technological changes that make the job skills of many
workers obsolete.
▪ Thus, it is these frictional and structural unemployment that constitute
the ‘natural rate of unemployment’.
▪ Since, the equivalent number are available for them, full employment is
said to prevail even in the presence of this natural rate of unemployment.

▪ This natural rate of unemployment is not constant but varies over time
due to changes in mobility and availability of information.
 Natural Rate Hypothesis

▪ Another important thing to understand from Friedman’s explanation is that

expectations about the future rate of inflation play an important role in it.

▪ Friedman put forward a theory of adaptive expectations according to which people

form their expectations on the basis of the previous period of inflation, and change or
adapt their expectations only when the actual inflation turns out to be different from
their expected rate.

▪ According to this Friedman’s theory of adaptive expectations, there may be

tradeoff between rates of inflation and unemployment in the short run, but
there is no such trade-off in the long run.
Natural Rate Hypothesis

SPC1 is the short-run Phillips curve and the

economy is at A0.

The location of A0 on the short run Phillips curve

depends on the level of aggregate demand.

Corresponding to A0,
Rate of unemployment = 5% of labour force
Rate of Inflation = 5% (on the basis of which
nominal wages have been set)

Now, suppose, the government adopts the

expansionary fiscal and monetary policies to raise
aggregate demand.

The consequent increase in aggregate demand

will cause the rate of inflation to rise to 7%.
Natural Rate Hypothesis

▪ Due to rise in inflation → price level will rise

▪ This rise in price level would raise the profits
of the firm → induce firms to increase their
output and employ more labour.
▪ More labour employed → Less unemployment
rate

Due to the higher rate of inflation and lower level

of unemployment, economy will move to A1.
Where, inflation rate = 7%
Unemployment rate = 3.5%

Note: In moving from point A0 to A1 on SPC1, the

economy accepts the higher rate of inflation as
the cost of achieving a lower rate of
unemployment.
Thus, this is in conformity with the Phillips curve.
Natural Rate Hypothesis

▪ But the advocates of natural rate

hypothesis says 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.
Natural Rate Hypothesis

▪ According to them, the economy will not

remain stable at A1.
▪ This is because workers will realise that due
to higher rate of inflation than the expected,
their real wages and incomes have fallen.
▪ The workers will therefore demand higher
nominal wages to restore the real income.

▪ As nominal wages will rise → profit of

business firms will fall to their earlier level.

▪ This reduction in profit implies that original

motivation to expand output and employment
will no longer be there.

▪ Consequently, the unemployment rate will rise

to the natural level of 5%.
Natural Rate Hypothesis

▪ Further at point B0, and with rate of inflation

at 7%, workers will now expect this rate to
continue in future.
▪ As a result , the short run Phillips curve shifts
upward from SPC1 to SPC2.

▪ Therefore, we can say that movement along

the Phillips curve is temporary.

▪ Thus, in this theory, the long run phillips

curve is a vertical straight line showing
that no trade-off exists between inflation
and unemployment in the long run.

▪ Also, any rate of inflation can occur in the

long-run with natural rate of
unemployment.
Relationship between Short-run Phillips curve
and Long-run Phillips curve
The position of a short-run Phillips curve which
passes through a point on the long run Phillips curve
depends on the anticipated (expected) inflation rate.

If the expected rate of inflation = 6%

So, the short- run phillips curve (SRPC0) passes
through the corresponding point ‘A’ with natural
employment rate of 6%.

SRPC0 The movement along the curve occurs as a result

of change in aggregate demand.
SRPC1
When there is unanticipated increase in aggregate
demand, inflation rate rises and causes a fall in
unemployment rate.

Now, inflation has become 8% and unemployment

rate is 4%.
▪ When the expected inflation rate changes,
the short-run Phillips curve shifts.

▪ When expected inflation rate is 6%, the

short run phillips curve is SRPC0.
▪ But when expected inflation rate falls to
4%, the short-run Phillips curve to SRPC1.
SRPC0
▪ The distance by which short run phillips
SRPC1
curve shifts to a lower position is equal
to the change in expected rate of
inflation.
 Conclusion on Phillips Curve

▪ Most economists would agree that in the short term, there can be a trade-off between
unemployment and inflation. However, there is a disagreement whether this policy is valid for the
long-term.

▪ Monetarists would tend to argue the trade-off will prove short-term, and we will just get inflation.

▪ However, Keynesians argue that demand deficient unemployment could persist in the long-term.
Boosting Aggregate Demand could lead to lower unemployment and a modest increase in inflation.

▪ But in an ideal situation, policymakers will aim for low inflation and low unemployment.
▪ To achieve this, we need economic growth that is sustainable (close to long-run trend rate) and
supply-side policies to reduce cost-push inflation and structural unemployment.

▪ If these criteria are met then it becomes easier to achieve this goal of lower inflation and lower
unemployment.
 Equation of Phillips curve
According to the Phillips curve concept, inflation depends on 3 factors:

1. Expected rate of inflation

2. The extent to which unemployment rate deviates from the natural rate
3. Supply shocks in the economy

The above 3 factors are expressed through the following equation of the Phillips curve:

ഥ +𝒗
𝝅 = 𝝅ⅇ − 𝜷 𝑼 − 𝑼
Where,
𝝅 = Inflation rate
𝝅ⅇ = Expected Inflation Rate
U = Total unemployment
ഥ = Natural unemployment
𝑼
𝑼−𝑼 ഥ = Cyclical unemployment
𝜷 = Parameter which measures the degree of responsiveness of inflation rate to the
rate of cyclical unemployment
V = Supply shock to the economy
 Important terms related to Inflation
Stagflation
▪ Stagflation is a period of rising inflation but falling
output and rising unemployment.
▪ Stagflation occurred in the 1970s following the
tripling in the price of oil.
▪ A degree of stagflation occurred in 2008, following
the rise in the price of oil and the start of the global
recession.

Causes of stagflation

Oil price rise:

▪ Stagflation is often caused by a supply-side shock.
▪ For example, rise in oil prices, will cause a rise in business costs and short-run
aggregate supply will shift to the left.
▪ This causes a higher inflation rate and lower GDP.
Powerful trade unions
▪ If trade unions have strong bargaining power – they may be able to bargain for
higher wages, even in periods of lower economic growth.
▪ Higher wages are a significant cause of inflation.

Falling productivity
▪ If an economy experiences falling productivity – workers becoming more inefficient;
costs will rise and output fall.

Rise in structural unemployment

▪ If there is a decline in traditional industries, we may get more structural
unemployment and lower output.
▪ Thus we can get higher unemployment – even if inflation is also increasing.
Stagflation and Phillips Curve

▪ The traditional Phillips curve

suggests there is a trade-off between
inflation and unemployment.

▪ A period of stagflation will shift

the Phillips curve to the right,
giving a worse trade-off.

▪ Phillips curve shifting to the right,

indicating stagflation (higher
inflation and higher unemployment.
 Concept Check

Q. A decrease in the price of foreign oil-

(A) Shifts the short-run Phillips curve downward and make the
unemployment inflation trade-off less favorable
(B) Shifts the short run Phillips curve upward and makes the
unemployment inflation trade-off more favorable
(C) Shifts the short run Phillips curve upward and makes the
Unemployment inflation trade off more favorable
(D) Shifts the short run Phillips curve downward and makes the
unemployment inflation trade off more favorable

Answer: (D) Shifts the short run Phillips curve downward and makes
the unemployment inflation trade off more favorable
Deflation

▪ Deflation is defined as a decrease in the

general price level.
▪ It is a negative inflation rate.
▪ Deflation means the value of money will
increase.

▪ Deflation is often associated with periods of

negative or stagnant economic growth.
▪ In fact, deflation is often used to express a
declining economy.

Deflation is considered harmful to economy because-

▪ People delay spending; hoping prices will be lower next year; this causes further
falls in aggregate demand and rate of economic growth.
▪ Workers resist nominal wage cuts. Therefore, real wages rise causing real wage
unemployment.
Deflation caused by rising AS (Aggregate Supply)

▪ However, if deflation is caused by rising productivity, improved technology and lower

costs, the deflation may not be harmful but beneficial.
▪ This shows how a shift in SRAS to the right causes lower price level.
Disinflation
▪ 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.
▪ During periods of disinflation, the general price level is still increasing, but it is
occurring slower than before.

Examples:

▪ Year 1 – Prices increased from 4% to 8% → Inflation

▪ Year 2 – Prices increased from 8% to 10% → Disinflation
▪ Year 3 – Prices decreased from 10% to 7% → Deflation

▪ 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.
Happy Learning!