The expectations augmented Philips curve Unemployment The expectations augmented Philips curve

Personalised Learning Checklist PLC 7 I understand the concept of, and the factors which determine, the natural rate of unemployment and both the short-run and long-run Phillips curves, and am able to discuss the implications of these for economic policy.

Learning outcomes To what extent is there a trade off between unemployment and inflation?

Definition of augmented To make (something already developed or well under way) greater, as in size, extent, or quantity http://www.thefreedictionary.com/augment

The (short run) Philips curve Professor A. W. Philips Data analysis of inflation and unemployment between 1861-1957 seemed to illustrate a trade off between the two. The relationship began to break down in the 1970’s with ‘stagflation’ (stagnant economy and inflation) Inflation % Unemployment %

Shifting the (short run) Philips curve Some economists argued that the short run Philips curve (SRPC) did exist in the 1970s, but that it had shifted to the right Workers were not ‘moderating’ their wage claims as inflation rose. Higher rates of unemployment became accepted. This means higher rates of unemployment would exist at each rate of inflation, e.g. At a 5% rate of inflation, higher unemployment would exist (B). Inflation % SRPC1 SRPC2 5 A B Unemployment %

Adaptive expectations Where workers experience inflation in the current period, they will expect higher inflation in the future. This will prompt higher wages claims and increased business costs. This gives rise to a potential wage price spiral

The (long run) Philips curve Point A is considered to be too high a rate of unemployment. The authorities engage in fiscal or monetary expansion. The increase in economic activity creates jobs and unemployment is reduced to B. Demand pull inflation or a tight labour market, causes prices to rise to 5%. This is incorporated into the new wages claims. Production costs rise and in an effort to cut costs businesses gradually reduce their work force leading to higher unemployment C. This is at the original level of unemployment A before the expansionary fiscal or monetary policy. Inflation % SRPC2 SRPC1 LRPC1 C 5 B A Unemployment %

The natural rate of unemployment (NRU) Free market economists state that it is impossible to reduce unemployment below the natural rate of unemployment (voluntary unemployment) without causing inflation through a wage price spiral

The non accelerating inflation rate of unemployment (NAIRU) The rate of unemployment at which there is no tendency to for inflation to rise.

Shifting the LRPC and the NRU to the left How To what effect Inflation % LRPC2 LRPC1 C 5 B A SRPC2 SRPC1 Unemployment %

Labour market supply side policies Policies aimed at improving the quality and quantity of the of the supply of labour available to the economy. They seek to match the labour force to the demands placed upon it by employers in expanding sectors. This will increase the productive potential of an economy and as a result full employment is likely to come at a higher real output. Income tax reform Improving incentives to work Education and training Trade union reforms Price level AS1 AS2 FE1 FE2 Real output