Inflation & Unemployment

PHILLIPS CURVE
ECN 2223
  Policy making is welcome when the governments can
maintain BOTH:
 Low inflation (lower rate of changes in the price level) and
 Low unemployment (or higher rate of output growth)
Inflation and
 Policy makers, however, often find themselves in a
Unemployment: dilemma when inflation and unemployment move in
a policy dilemma opposite directions
 Economist A.W. Phillips discovered an inverse empirical
relationship between wage inflation and unemployment
in 1958, which gave birth to the Phillips Curve
 If unemployment is
greater than that its
“natural rate” at potential
output level, then nominal
wages fall (rate of change
is negative)

Initial Phillips Whenever the

unemployment rate is
Curve smaller than its “natural
rate” then, wages will rise
(rate of change is positive)

Workers’ and Employers’

bargaining power
depends on the level of Natural rate of
unemployment unemployment
  Later wage inflation was
replaced by price inflation,
because:
 Prices and nominal wages
Prices and move closely and, in
unemployment competitive market
environment and
 P = MC = W/MPL

 Policy implication of the

Phillips curve is that
unemployment can be
reduced by allowing inflation
to rise
  As reduction in
unemployment and
increase in output are
closely related (assuming
a constant productivity
growth growth), Phillips
curve can show the
positive correlation
Inflation and between inflation and
output growth
output
 If the economy is above
the potential output level,
then there is an increase
in inflation
 It also supports the idea
of an upward-sloping AS Potential
curve output level
  Milton Friedman and
Edmund Phelps argument is
in favour of flexibility in
prices and wages, leading to
Monetarists’ real wage restoration in the
long-run
augmented LR
 Secondly, workers act on
restoring their nominal
wages, on the basis of
Phillips curve “inflationary expectations”
 Therefore, there is a
separate Phillips Curve (PC)
SR
at each level of inflationary
expectation, which gives the
vertical LRPC and it
corresponds to the LRAS
curve
  Modern Phillips curve substitutes wage inflation with
Modern price inflation
Phillips curve,  Modern Phillips curve includes inflationary
expectations as well due to the developments of Milton
compared to Friedman and Edmund Phelps
its initial  Modern Phillips curve also include supply shocks to the
version inflation-output relationship, which began with 1973 oil
shocks causing stagflation