Significance of Inflation Expectations in the Monetarist Phillips Curve - Essay Example

? The Significance Of Inflation Expectations In The Monetarist Phillips Curve And The Implications For The Conduct Of Economic Policy Inflation has been one of the most widely discussed topics by economist of the twenty first century. The term can simply be defined a general and persistent increase in the price level over a period of time. Major economies of the world have been affected by it and economic analysts throughout the world have put in their expertise to curtail the damages that inflation is capable of doing to an economy. Mr. Alban William Phillips was one of those economists who will always be remembered for his contribution to the world of economics. He’s gathered fame all over the world for his research on inflation and unemployment. He started his work by gathering ninety five years of data relating to the UK wage inflation and unemployment. He was of the view that there is some direct or indirect link among these two important economic indicators. When he plotted the data on a graph, Mr. Phillips concluded that there is an inverse relationship between the rate of unemployment and the level of inflation in an economy. According to Mr. Philips there was a tradeoff between unemployment and inflation. High levels of unemployment tend to be linked with low levels of inflation and vice versa. Accordingly, if the government would want to reduce the unemployment rate it then it would have to settle with high rates of inflation. The Phillips curve concluded that deciding upon whether to have high rates of unemployment or to go for high rates of inflation was merely a matter of government policy as the two of them could not be achieved together – they were mutually exclusive. So how does this basic economic concept work? Basically what happens is that when the rate of unemployment decreases, more people tend to be employed. When more people are employed, more incomes are given out. Now when people have more money in their hands they will definitely demand more good and services then before and so the overall demand for goods and services in an economy will rise. Basic economics comes in to play and the overall demand curve would shift to the right hand side showing an increase in demand. Assuming supply is inelastic in the short term, the consumer equilibrium will now be achieved at a higher price level than before. And this is how the price level rises and inflation occurs. The Phillips curve can further be divided into two time phases, namely the long run and the short run Phillips curve. The two curves are slightly different from each other in that they depict a different side of the picture. In the short run Phillips curve, high rates of unemployment are associated with low rates of inflation and vice versa. In such a situation the economists generally have to take a decision as whether to contain inflation or unemployment. Choices will generally be made after taking the overall economic situation of a country into consideration and definitely the decision made will not be beneficial for all. If the government decides to go for low rates of unemployment, low income earners will face a burden of high prices due to inflation. However, the long term Phillips curve looks at the story from a very different angle. The long run Phillips curve is normally drawn as a vertical line. This line can move both ways but generally it tends to move in (to a lower rate of unemployment) as time passes by. The idea behind long term Phillips curve is that in the long term there will be a certain rate of unemployment regardless of the level of inflation. This level will remain there since some people will always be unemployed due to job switching, frictional and seasonal unemployment. According to Mr. Friedman Milton, an economist, there is no tradeoff between the rate of unemployment and the rate of inflation in the long run as is denoted by the vertical Phillips curve. According to the long run Phillips curve, efforts made by economists to reduce the unemployment level below the natural rate of unemployment (NAIRU), by causing an increase in the aggregate demand for goods and services will yield little or no results. The main rationale behind this point is that in the long run there will always be some level of unemployment as people search for right jobs or become seasonal unemployed. In such a situation an increase in the aggregate demand will cause prices to go up and hence inflation will prevail. The main question of concern and the reason why I’m writing this paper is why and how does the study of Phillips curve matter to us. I would like to discuss the implications Phillips curve has on the conduct of our economic policy. To start off, every government sets various targets in its budgets which it plans to achieve by the time year ends. These targets amongst many others include target rates for inflation and unemployment. The Phillips curve helps the government to decide what rates of unemployment and inflation to settle with for the current year and makes budgeting easy. Another implication faced by the policy makers is the determination of market interest rates with regards to the current level of inflation. If the level of inflation is high then according to the Phillips curve the unemployment level should be low. To reduce the level of inflation, the government might decide to increase interest rates so that people prefer saving their money rather than simply spending/consuming it. When savings are done, the amount of money flowing in the economy goes down and as a result the job markets shrink drastically and as a result the unemployment level increases. This has multiple effects on the growth of collective demand as high interest rates work their way to an entire economic system through the economic transmission mechanism. Figures of inflation and unemployment are also very important for economic analysts as they help them in making decisions about key economic policies like monetary and fiscal ones. As a simple example, inflation figures help the government decide how much money to keep aside for defense, medical and other major public services. If inflation is not taken care of when budgeting then there would be a significant difference between the amount budgeted for and the actual expenditure and the government would then have to take important midterm measures to overcome deficiencies caused by the havoc of inflation. Now let’s see how these two factors, namely unemployment and inflation are really important for policy makers. In simple terms inflation affects us when we go to a grocery store for shopping and find out that for a fixed amount of money we’re not able to get the basket of goods which we were previously able to. The same thing applies to prices of all other kinds of goods. What has basically happened is that due to inflation, money has lost its worth and now the same quantity of goods will be purchased for higher amount of money. Inflation has its benefits as well as its negative effects on an economy. However, it needs to be monitored regularly to make sure it doesn’t harm the economy. During the times of inflation businesses tend to invest their money in assets and securities rather than keeping liquid cash. When inflation occurs, the prices of such assets increase in line with the overall price level and so in the long term investors are able to preserve the real value of their investment even when the currency loses its worth. It also encourages people to invest their money rather than keeping it home and losing its value. Borrowers of money tend to benefit from inflation as in real terms they’ll have to pay a lesser sum of money to settle the same amount of debt. Lenders need to make sure they give out loans on terms which take inflation into account so that they don’t lose out on their money by the time they get it back. Inflation is associated with many economic problems. If the government fails to decide on a correct rate of inflation from the Phillips curve analysis then it will have multiple economic effects. A high rate of inflation will bring about a fall in our export earnings as now our goods will become expensive as compared to those of manufacturers from other competing countries. Not only will we lose out on our export earnings, but even unemployment level will increase as there will already be excess produce which wouldn’t have found a market yet. If inflation isn’t controlled at proper timings then the results will be disastrous. Often times governments decide upon an inflation rate and then take measures to make sure the market rate sticks by the pre decided bench - mark rate. This is often done by central banks by regulating money supply and lending rates. Higher interest rates reduce the money supply as the marginal propensity to save increases and thereby inflation rates go down. Goods can also be imported from and exported to other countries to maintain an effective price level and thereby cancelling the effects of inflation. If we look into the recent past, in 2009 inflation rates throughout the world went down drastically as the recession hit American economy demanded less goods (and subsequently prices also went down). Now as the world economy recovers from this recession, economic decision makers keep the interest rates low so that an average person’s marginal propensity to consume increases and there by the overall demand for goods and services in an economy goes up. When demand will go up, more goods will be produced and to produce more goods more people will be employed. And this is how the overall circulation of money in an economy will be increase thereby causing an economy to make a recovery from the recessionary state. There are some key points relating to the Phillips curve which I now feel should be appropriately brought into this discussion. Firstly, in the short run there is a tradeoff between unemployment and inflation as we all know. In such a case if aggregate demand increases to a level outside the current production possibility curve, then unemployment rate will go down but there will be an alarming risk of an increase in the rate of inflation. Secondly, supply related policies which bring an increase to the level of production in an economy can cause the long run Phillips curve to shift inwards. When that happens the natural rate of unemployment will go down regardless of the levels of inflation in the economy. Thirdly, changes in the expected rate of inflation alter the station of the short run Phillips curve on the graph. In such a case an expected dip in the inflation rate will bring about a downward/inward shift in the short run supply curve. To sum it all up, there is a crucial link between the Phillips curve and its effects on the conduct of a nation’s economic policy. Policy makers need to sit down together and decide which economic indicator they need to pay most attention to and then divert their resources towards its achievement. If a nation wants to keep its inflation rate low then market interest rates should be increased so people invest more money and there remains little money for people to consume. Low rates of consumption would lead to low demand for goods and the inflationary pressure will go down. Bibliography Top of Form FUHRER, J. C. (2009). Understanding inflation and the implications for monetary policy: a Phillips curve retrospective. Cambridge, MA, MIT Press. Bottom of Form Top of Form BAUMOL, W. J., & BLINDER, A. S. (2002).Macroeconomics principles and policy. Princeton, N.J., Recording for the Blind & Dyslexic. Top of Form KARANASSOU, M., SALA, H., & SNOWER, D. (2003). The European Phillips curve: does the NAIRU exist? Bottom of Form Bottom of Form Read More