The Analytical Foundations of the Phillips Curve - Essay Example

Analytical foundations of the Phillips curve 12th March Introduction Philips curve involves a historical inverse relationship that exists between the rate of inflation and level of unemployment. Having been discovered by AW Philips, a British economist, Philips curve has become one of the important tools used to undertake a macro-economic policy. During 1950s, the major tool that was used to manage the trade cycle was the fiscal demand management. In this period, the policy makers used to constrain the aggregate demand when faced with inflation and stimulate it during unemployment and recession (Tejvan, 2013). Similarly, most of the policy makers believed that unemployment and inflation could not occur at the same time and whichever occurred, it became a major determinant of the policies that would be adopted by a given economy. Another issue that the economists believed was that it was possible to achieve one objective without having negative implications on the other. However, the research that Philips undertook in 1958 provided information that generated quite a number of questions to those assumptions. On his part, Philips used the available UK data to make an analysis on the rates of inflation and unemployment in UK. After plotting the result of the research, Philips noted that there existed an inverse relationship between wage inflation and unemployment. As a way of checking the relevance of the Philips conclusion, other economists used price inflation instead of wage inflation and noted that the results were similar curves and this became the origin of the Philip curve. This paper seeks to discuss the analytical foundations of the Phillips curve as well as how unemployment rate of 5% may be inflationary in one country, while it is deflationary in another country. During his studies on the relationship between unemployment and wage inflation between 1860 and 1957, Philips plotted the data and came up with the relationship indicated by the graph below. Inflation Unemployment According to the curve, any change in the level of unemployment produced a predictable as well as direct impact on the level of price inflation. Philips, together with other policy makers adopted the relationship between the two variables and noted that an increase in aggregate demand as well as fiscal stimulus in the economy triggers various responses. First, they noted that an increase in demand as the spending by the government rises results into national growth. This is followed by falling on the pool of unemployed. On their part, firms will be involved in competing for fewer workers available in the economy by increasing their nominal wages making the workers to have a higher bargaining power as they seek to have their nominal wages raised further (Forder, 2014). As the economy gets near to full capacity, there is an occurrence of inflationary pressures. The level of unemployment reduces as the workers demand for higher wages resulting to wage inflation. On their part, firms raise prices as the result of increased demand (Blanchard and Galí, 2007). As the result, the economy experiences a decreasing level of unemployment but a rising level of inflation. Philips curve breakdown Unemployment According to the evidence that was got in 1970s, there was a breakdown on the trade off between inflation and the level of unemployment. During this period, stagflation, which implies the period of rising inflation and unemployment, occurred. One of the notable causes of the economic crisis that broke the inverse relationship between the inflation and the level of unemployment was the Barber Boom of 1970 to 1973. This was a period of rapid economic growth that was characterized by three major occurrences. First, there was a sudden deregulation of the mortgage market by the Bank of England. High Street Banks were given the liberty to lend mortgages, an aspect that resulted to increased house prices as well as consumer wealth. Secondly, the 1972 budget introduced a large tax cuts despite the high economic growth that existed. Thirdly, there was a mass use of credit cards resulting to occurrence of consumer bubbles. Other issues that occurred included rising wages as the result of strengths of unions, increased consumer spending and a 70% increase in oil prices. As the result of stagflation, Philips curve shifted to the right which was an indication of a worse trade off and cost-push inflation. However, in 2000s, the tradeoff improved. For example, in UK the reduction on the level of global inflation made the level of unemployment to reduce without any rise on the level of inflation. The trade off also improved during the time of Great Moderation. During this time, economic stability took place. Most of the countries experienced low inflation, end of boom and bust cycle, wage growth and positive economic growth. As the result of recession and reduction of oil prices in 2008, the global economy experienced a rise on the level of unemployment and a fall in inflation. Keynesian’s view on the Philips curve Keynesians argue that there exist a demand deficient unemployment and incase a recession occurs; the unemployment is reduced by demand side policies (Gordon, 2011). Demand deficient unemployment occurs in case there is insufficient demand in the economy to make the employment attain full capacity. According to the Keynesian views, if the demand in the national economy falls, firms will sell fewer products making the level of production to reduce. As the result of low level of production, firms will lower their demand for workers. Similarly, firms can take the option of firing their employees or stop recruiting new workers to avoid higher labour cost. In some cases, the demand may fall to a very low level, a situation that can make everyone to become redundant and companies to go bankrupt for example in the case of Borders and Woolworths. One of the notable aspects of demand deficient unemployment is that the rate of unemployment among the young employees mostly rises during a recession. Even though older workers are also laid off, the young workers are mostly affected since firms do not hire new workers. According to the Keynesians, firms like to cut back on recruiting new workers instead of making the existing workers redundant. Another key aspect of the demand deficient unemployment is that it is possible to experience it even though there is a growth in the economy. For example, if a long run trend rate of 3% is experienced in the economy, it implies an annual productivity of 3%. Assuming the demand grows by 1%, there is an increment in spare capacity resulting to an increased demand deficient unemployment. Monetarist’s view of Philips curve Despite their contribution on inflation and unemployment, Monetarists have always questioned the Philips curve trade off. According to monetarists, in the long run there is no trade off between the rate of inflation and unemployment since in the long run the aggregate supply is inelastic. According to the monetarists view, if there is an increase in the level of aggregate demand, then workers will forcefully ask for higher nominal wages. After getting higher nominal wages, workers will in turn work for more hours since their perception is that the real wages has increased. Monetarists thus argue that workers price expectations are based on last year. Additionally, they indicate that as the result of the increased aggregate demand, inflation occurs thus making the real wages to stay at the same position. Once the workers realize that there is no change in the real wages, they becomes reluctant to provide extra labour making the real output to return to the original position. As the result, monetarists indicate that the level of unemployment remains unchanged as the rate of inflation rises. Relevance of Philips curve today In the contemporary economic environment, many policy makers and central banks are contemplating on the extent to which they should reduce inflation and the level of unemployment. For instance, Federal Reserve is making a consideration on the use of monetary policies to achieve a predetermined unemployment level and to accept a rise if inflation. Another good example occurred between 2009 and 2013, when the Bank of England tolerated an inflation of more than the government target of 2% since the bank was of the opinion that by reducing the inflation, there would emerge serious problems such as slow economic expansion and increased level of unemployment (Romer, 2012). The aspect of willingness to accept higher inflation rates is an indication that trade off of higher inflation is more valued that the benefit of lower unemployment by the policy makers. However, it is worth for the policy makers to make an extensive research on the implications of raising the rate of inflation. This is based on the fact that if inflation is not closely monitored, it will result to loss of monetary policies credibility as well as emergence of inflationary pressures. Inflationary versus deflationary For a country that is experiencing unemployment rate of 5%, is an indication that it has wide range of resources such as oil thus creating more work opportunities. This leads to high demand for products resulting to hike in prices causing inflation. Likewise, another country with unemployment rate of 5% may be due to lower population and increased resources thus making the firms output to increase but the demand is low leading to lower prices and deflation. Conclusion Based on the above analyses on Philips curve, it is clear that the tool cannot be overlooked in the current economic scenario. Despite the loss of trade off that was experienced in 1970s, Philips curve has gained importance as macroeconomic analyzing tool. Most economists agree that a trade off between inflation and unemployment may exist but they also disagree on the policy in a long term. While Keynesians indicate that demand deficient unemployment may emerge in long term, monetarists, who stresses on supply sides of the economy, argues that the trade off will be short term. References Blanchard, O and Galí, J. 2007. Real Wage Rigidities and the New Keynesian Model. Journal of Money, Credit, and Banking 39 (1): 35–61 Forder, J. 2014. Macroeconomics and the Phillips curve myth. Oxford: Oxford University Press. Gordon, J. 2011. The History of the Phillips Curve: Consensus and Bifurcation. Economica 78 (309): 10–50. Romer, D. 2012. Dynamic Stochastic General Equilibrium Models of Fluctuation. Advanced Macroeconomics. New York: McGraw-Hill Irwin. Tejvan, P. 2013. Phillips Curve. Available from http://www.economicshelp.org/blog/1364/economics/phillips-curve-explained/ Read More