THE PHILLIPS CURVE THE SHORT RUN PHILLIPS CURVE THE LONG RUN PHILLIPS CURVE

The Original Phillips Curve In 1958, New Zealand economist Alban Williams Phillips, proposed the concept of the Phillips Curve. He argued there was a tradeoff between inflation and unemployment. If you had high inflation due to a booming economy, you would have low unemployment. If you had high unemployment due to a recession, you would have low inflation (due to low levels of aggregate demand).

The Original Phillips Curve

Problems with the Phillips Curve The 1970s In the 1970s, the US experienced a series of oil shocks (oil / gas shortage) which resulted in high inflation and high rate of unemployment in the US. This led to a problem of stagflation. The Phillips Curve is Challenged by the Neo Classical School, who make a distinction between a short run and long run curve.

Critics of the Phillips Curve: Milton Friedman It was the monetarist economist led by Milton Friedman who were the biggest critics of the original Phillips curve. According to their analysis there is no trade of between inflation and unemployment, in the long term. This is consistent with their explanation of classical long run aggregate supply – the economy will automatically tend towards its long run equilibrium at the full employment level of output.

PART A Assume that the economy is in long-run equilibrium at point A on the SRPC 1. (Short Run Phillips Curve). The labor market is also in equilibrium so that the only unemployment that exists is the natural unemployment of 6%. The inflation rate is 2%. People expect inflation to be 2% and negotiate any pay increase based on this expected rate. Now consider what would happen if the government decided that they wanted to reduce unemployment and adopted a demand-side policy (eg: increase in government spending). Aggregate demand would increase and this would lead to an increase in the demand for labour and so an increase in the wage level. However, at the same time there would be an increase in the inflation rate, in this case to 6%.

PART B: In the short run there would be a fall in unemployment as workers who had not been prepared to take jobs at existing wage levels before are now attracted by what they think are higher wages and the economy moves from A to B on the diagram. However, there are higher nominal wages and real wages have not risen. In this case, we would say workers have suffered from money illusion. When the workers realize that their real wages have not risen, they leave their jobs and unemployment goes back to the natural rate, but now at an inflation rate of 6%.

PART C The economy does not return to point A. Now that inflation is running at 6%, people will expect prices to rise at 6% and negotiate an equivalent increase in wages. The economy will move to point C on the diagram – SRPC 2. Unemployment has returned to it natural rate at higher rate of inflation. Any attempt to use demand management again to reduce the unemployment below this natural rate will only result in higher inflation (C to D to E) and the move to another short run Phillips Curve, SRPC 3

The Natural Rate of Unemployment & Expansionary Fiscal Policy The natural rate of unemployment is the unemployment rate that is consistent with a stable rate of inflation. As long as governments do not use expansionary policies, inflation will not accelerate at the natural rate of unemployment. However, if expansionary policies are used, then inflation will accelerate.

A Vertical Long Run Phillips Curve Neo-Classical School The long-run Phillips curve is vertical at the natural rate of unemployment (NRU). At any given point in time, there may be a short run trade off between inflation and unemployment, but the economy will always return to unemployment at the natural rate. Governments cannot reduce this by using demand management policies. The natural rate of unemployment is the unemployment that occurs when the economy is at full employment and the labour market is in equilibrium.

How do we reduce the natural rate of unemployment? SUPPLY SIDE POLICIES ARE THE KEY TO REDUCING THE NATURAL RATE OF UNEMPLOYMENT Supply side policies will shift the long run Phillips Curve to the left from LRPC1 to LRPC2. This would be the equivalent of a rightward shift in the long-run aggregate supply curve or an outward shift in a country’s production possibilities curve.

How to reduce different types of unemployment (Reminder!) Demand side policies may be appropriate for reducing cyclical, demand-deficient unemployment, but not for reducing the frictional, seasonal and structural unemployment that make up the natural unemployment.

Estimating the Natural Rate of Unemployment The OCED admits that the natural rate of unemployment can only be estimated with uncertainty. Still estimates of the NRU are made. It is evident that the NRU varies considerably over time and between countries.

Why do countries have a different NRU? Differences between countries are due to a number of different things, including the availability of unemployment benefits, trade union power, the extent of labor market regulations, and wage setting practices by firms. Countries with more benefits and considerable regulation of labor markets tend to have a higher NRU. When organizations like the OCED, recommend that countries make labor market reforms to reduce unemployment, they are usually referring to measures that will reduce the natural rate.

REVIEW QUESTIONS 1. Using an appropriate diagram, explain why there might be a trade off between unemployment and inflation in the short run. Include numbers with your diagram to demonstrate real understanding. 2.Explain two policies that might be used to reduce the natural rate of unemployment.

NRU or NAIRU?? Instead of referring the NRU, many countries refer to the concept of NAIRU. In a response of about 120 words explain this concept. Use this website: nemp/nairu.htm nemp/nairu.htm

Natural Rate of Unemployment: The US vs the Euro Zone Conduct appropriate research to answer the following: 1.What is the natural rate of unemployment for the US? 2.What is the natural rate of unemployment for the Eurozone or choose a specific country in the Eurozone? 3.Why is the natural rate of unemployment in the Eurozone higher than the US? Include the appropriate sources for your information.