AQA 2.3 Economic performance 2.3.4 Possible conflicts between macroeconomic policy objectives Recap year 1: How do negative and positive output gaps relate to unemployment and inflationary pressures? Give two examples of how economic policies may be used to try to reconcile possible policy conflicts both in the short run and the long run. Using macro-economic models, including AD/AS, analyse two possible conflicts between policy objectives in the short run and long run. AQA 2.3 Economic performance

2.3.4 What you need to know How negative and positive output gaps relate to unemployment and inflationary pressures Both the short-run Phillips curve and the long-run, L-shaped Phillips curve The implications of the short-run Phillips curve and the long-run, L-shaped Phillips curve for economic policy That the L-shaped Phillips curve is also known as the vertical long-run Phillips curve How economic policies may be used to try to reconcile possible policy conflicts both in the short run and the long run How to use macro-economic models, including AD/AS, to analyse the possible conflicts between policy objectives in the short run and long run How approaches to reconciling conflicts may vary, and the monetarist/supply side view that the major macroeconomic objectives are compatible in the long run

The Phillips Curve In 1958, A.W. Phillips studied the relationship between unemployment and the rate of change of money wages Given that wages are a key driver of inflation, Phillips suggested that there was a trade-off in the short–run between unemployment and inflation The implication of this for government policy was that a certain level of unemployment could be traded off against a certain level of inflation

How strong do you think the relationship is? The Phillips Curve How strong do you think the relationship is? Phillips’ original data points shown here are from 1861-1913, and a line of best fit has been added. Source: www.significancemagazine.org

The Short-Run Phillips Curve Unemployment rate Inflation rate U1 P2 P1 U2 Phillips’ work suggests that changes in unemployment have direct and, to some degree, predictable effects on inflation, and therefore have implications for economic policy makers e.g. lower inflation is achievable at the expense of a higher rate of inflation The Phillips Curve is not therefore a theory of inflation, but illustrates the conflict between two objectives For example, assume the economy is at point X, and wishes to reduce unemployment to U2, it may increase government spending and therefore aggregate demand in order to move the economy to point Y. However, this is at the cost of higher inflation at P2 because the pool of unemployed workers will fall, firms will compete for workers by raising wages, thus increasing wages costs, which are passed on in the form of higher prices Y X

The Breakdown of The Phillips Curve Stagflation is when an economy experiences both high inflation and high unemployment at the same time. The Phillips Curve was an important breakthrough in helping to establish that one of the key causes of inflation was through excessive aggregate demand As more people become employed, AD rises, which contributes towards demand-pull inflationary pressure In addition, when unemployment is low, workers may be in a stronger position to bargain for higher wages, which leads to an additional cost-push inflationary pressure However, in the 1970’s Phillips’ relationship between unemployment and inflation began to break down in the UK as high unemployment and high inflation began to occur together i.e. stagflation In addition, the model did not recognise the impact that changes in the supply-side of the economy might have As a consequence, it has become accepted that the original Phillips Curve is an effective model in the short-run, but a new long-run model was required http://www.bbc.co.uk/news/business-26888516 India elections: Where do parties stand on the economy? How can the Indian economy be fixed? What is the current state of the Indian economy?

The Non-Accelerating inflation rate of unemployment (NAIRU) To help understand the long-run Phillips Curve, it is important to understand the concept of the NAIRU. The NAIRU is the level of unemployment where there is no inflationary pressure The short-run Phillips curve showed that as unemployment fell, aggregate demand would rise and so create inflationary pressure However, due to the existence at times of supply-side slack, it is possible to reduce unemployment without creating inflationary pressure However, beyond a certain point, any reductions in unemployment will lead to inflation This point is known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) It is an extension of the concept of the Natural Rate of Unemployment (NRU) outlined in 2.3.2 The NRU and NAIRU are both terms often used by economists.

The Long-Run Phillips Curve (The L-Shaped Phillips Curve) Milton Friedman and Edmund Phelps helped to develop the idea of the long-run Phillips curve, which showed that trade-offs between inflation and unemployment are not possible A crucial point here is the role of expectations. This concept in economics states that if economic agents experience inflation, they will adapt their behaviour and bid for higher wages. Equally, firms may believe revenues will rise with higher prices. One of the criticisms of the original Phillips curve was that it only considered the current rate of inflation, not the expected rate It is assumed that individuals base their expectations of future inflation on the current rate of inflation It is also considered that workers suffer from money illusion – the idea that price inflation has not been expected or anticipated, and so when workers receive nominal wage increases they falsely believe they will be better off because they have not fully recognised that price inflation will reduce the real value of wages Classical economists such as Friedman argue that long-run aggregate supply is vertical and that in the long-run trade-offs are not possible The Long Run Phillips Curve is therefore drawn as vertical to show the limited relationship between unemployment and inflation

The Long-Run Phillips Curve (The L-Shaped Phillips Curve) Imagine an economy is in equilibrium at point A, with U at its natural rate and inflation of 2%. The government may wish to reduce U to U1 and so boosts AD to achieve this. If successful, U will reduce to U1, and through higher wages, because of the diminishing pool of labour, inflation will rise to 5% at point B. However, inflationary expectations remain at 2%. In the short run more workers enter the labour market or work longer hours in the false belief that real wages have risen (i.e. money illusion). The new inflation rate of 5% has now become embedded in workers’ expectations. However, when workers realise that prices have actually risen they will see through the money illusion. Increased labour costs for firms means that they are no better off in real terms as prices rise. They therefore change their inflationary expectations and reduce their supply of labour. However, because workers have now adjusted their expectations of future inflation, they bargain for higher wages and the SRPC moves to SRPC2 with unemployment back at its natural rate, but now with a higher rate of inflation at 5%. U (%) 5% U1 U(natural) A C SRPC2 SRPC1 B Inflation (%) LRPC 2%

Implications of the Long-Run Phillips Curve The LRPC, or L-Shaped Phillips Curve, demonstrates that any attempts to reduce unemployment below its natural rate would only lead to inflation Therefore, attempts by government to reduce unemployment through expansionary policies that seek to boost aggregate demand are ineffective and simply create another problem Consequently, the theory of the LRPC demonstrates that improvements must be made to the supply-side of the economy Due to the role of expectations in the model, governments should also attempt to keep control of inflationary expectations amongst all economic agents It has been argued by some economists that the government decision to make the Bank of England independent in 1998 with sole responsibility for monetary policy and the inflation target, has helped to anchor inflationary expectations around the 2% level

Implications of the SRPC and LRPC on Government Policy There is a tendency for economists to agree that there is a trade-off between unemployment and inflation in the short-run However, in the long-run, the relationship is not so secure Consequently, if governments wish to aim for both low unemployment and low inflation, they need to carefully balance both demand- and supply-side management polices For example, as Keynes advocated, there could be significant levels of demand-deficient unemployment during a recession and if the negative output gap was not closed through stimuli to aggregate demand, unemployment would persist Monetarist/supply-side economists however argue that major macroeconomic objectives are compatible in the long run with effective policies that ensure the supply-side of the economy is fully flexible Therefore, we need economic growth that is close to the long term trend rate and effective supply-side policies to reduce issues associated with the natural rate of unemployment

Split the class into four Consider two economic problems: Class activity Split the class into four Consider two economic problems: High inflation with low unemployment High unemployment with low inflation Research and present how either Keynesians or Monetarists would solve one of these conflicts

Implications of the SRPC and LRPC on Government Policy If the government wishes to reduce the natural rate of unemployment, then policies that enhance the supply side of the economy and labour market are more appropriate, given the issues highlighted by the LRPC theory Policies should therefore focus on reducing the problems caused through frictional and structural unemployment Such policies might include: Education and training to enhance skills and employability Reducing JSA to enhance incentives to work and reduce the unemployment trap Encourage firms to offer flexible working patterns Improve job centres/job information to help workers Improve geographical mobility through e.g. affordable housing Look carefully at the policies suggested to improve frictional and structural unemployment. Which would you advocate and why? What are their limitations?

The Phillips Curve Today At the current time the UK is experiencing a sustained period of low inflation and a falling rate of unemployment Whilst this may indicate that the achievement of both objectives is achievable, this can only be considered to be a short-run phenomenon Although the overall level of unemployment may have fallen, there are regional pockets within the UK that have not experienced this and there is evidence of ‘under-employment’ Economic growth has been somewhat subdued, and there is evidence that the Bank of England would prefer to see higher inflation closer to the target rate in order to continue to reduce unemployment and increase wages There is concern that low inflation will become embedded in workers and firms expectations and consequently stifle wage growth and living standards It is vital therefore to continually monitor the current economic climate and track changes in policy and expectations

Test Yourself Here are 5 new terms you have learnt in this topic. Can you explain each one? Short Run Phillips curve Stagflation Long Run Phillips curve Money illusion NAIRU What are the Bank of England’s predictions for the future of the UK economy? http://www.bbc.co.uk/news/business-36974551