Phillips Curve and Its Implications - Case Study Example

of the of the The Phillip’s curve is one of the tools which have greatly contributed to the understanding and development of macroeconomic analysis. Its comprehensive analysis of the trade-off between inflation and unemployment has been the focal point or the benchmark to the policy makers. The most important aspect is to understand the short run inverse relationship between inflation and unemployment (Atkinson & Stiglitz, 1980). It also explains the dependency of inflation on the expected inflation and on the deviation of unemployment from the natural rate of unemployment. Inflation is the persistent increase in the prices of goods and services generally in the economy. This can be as a result of various reasons such as increase in the nominal wage rate, increase in liquidity in the system and other expansionary measures that are taken by the monetary authority and the government (Brunner & Meltzer, 1976). Unemployment on the other hand is a situation whereby the labor supply is more than the labor demanded. People who are able and willing to work at the prevailing wage rate cannot secure employment. Some section of unemployment is uncontrollable as this is important to keep inflation at controlled level. This is also because at any point of time, people will be seeking job as the labor market will always remain active. A heated economy occurs at low unemployment rates but the economic policies should always ensure a trend towards full employment whereby unemployment rate is below 4%. A safe trade between inflation and unemployment is considered feasible within this percentage (Friedman & Laidler, 1975). However, according to Phillip’s curve, as stated above, some element of sacrifice must be encountered to reduce unemployment. Reduction of unemployment in the system has a tendency of increasing inflation. This occurs because spending will increase causing a total overhaul in the price of goods and services. This becomes persistent as this rate climbs higher with every reduction of unemployment status of that economy (Arrow & Hahn, 1971). This means that in the short run, there is an inverse relationship between inflation and unemployment. However, in the long run, this rate of unemployment sets to natural rate of unemployment from whose deviation by unemployment, inflation rate can be obtained (Jossa & Musella, 1998). This is where increasing any spending will have no effect in controlling inflation but will just increase monetary variables. The natural rate of unemployment is the rate at which the labor market balances. The real wage is at the free market whereby the aggregate supply of labor is in balance with the aggregate demand for labor. In this case, the employment seekers at the prevailing wage rate have bowed down to involuntary unemployment and have been employed. However, others who cannot work at that rate are still expecting to get employments with higher wage rates. As unemployment rate goes below the normal rate, the nominal wage increases. Firms react to this by increasing their prices and the price level in the economy goes higher. Normally, workers ask for higher wages to counter the effect of high prices and to maintain their normal level of consumption. When this happens, the nominal wage will go higher and still the prices will be increased by the firms, and conversely prices increases further. This trend will continue between prices and wage which results in wage and price inflation. This shows that unemployment below the normal rate i.e. the natural rate of unemployment hurts the economy in various ways. It sets in wage and price inflation within the short run period. It also increases expectation of the inflation to continue going higher. This means that for an economy to ‘breathe’, unemployment cannot be kept below the natural rate of unemployment. This has the following implications; I. The actual rate of inflation is the same as the expected inflation rate II. Any expansionary measure implemented will only increase monetary variables According to the Phillip’s curve in graph 1, in the long run, the curves become vertical. This implies that as unemployment decline below the normal rate, inflation increases further. This therefore means that the long run Phillips curve becomes vertical at the natural rate of unemployment, such that the expansionary policies serve only to increase monetary variables. Graph 1 The graph below shows inflation rate is shaped by deviations in the unemployment rate in the long run. Inflation rate [%] against unemployment rate [%] in the long run LRPC2 LRPC1 Inflation rate [%] 3% Short run Phillip’s curve1 Short run Phillip’s curve2 Decrease in inflation expectations 4% 6.5% unemployment rate [%] Source: Author The curve shows that any attempt by the government to reduce unemployment through expansionary measures will have little or no advantage in the long run. It will only increase inflation further. This is occurs especially if the government intends to reduce the rate of unemployment below the natural rate of unemployment. For instance, if the government increases the demand by boosting or encouraging aggregate demand by any means, the effect will be that of increased prices of commodities in the economy. These will in turn increase inflation and inflation expectations. This continues unless a comprehensive and tight control of money and credit is adopted by the monetary policy makers. Thoroughly thought for and credible monetary policies that always look into the future can also cause serious decline of inflation expectations without taking expansionary measures. This can be concluded that when unemployment rate exceeds the natural rate of unemployment, the inflation rate decrease but when the unemployment rate is below the natural rate of unemployment, the inflation rate increases. The measure of monetary policies generated and implemented by the monetary authority and the government determines the state of inflation and unemployment trade off. The aims of the government and its agenda in a fiscal year can be felt as an introduction of a shock in the economy if its aims are to reduce unemployment below the natural rate of unemployment. A controlled mechanism to induce a reduction of unemployment should be guided by the natural rate of unemployment so as to avoid inflation or expectations of inflation. As normal, the economy will react to expectations of inflation not until the monetary authority comes with comprehensive policies to counter the lost confidence in the stability of prices of goods and services. Inflexibility in the labor market is the inability and unwillingness of labor to respond to changes in the market situations. These market situations can be for instance, changes in the demand for labor or changes in the wage rates. It is a very important analysis since it shows how labor market’s inability to adjust alters labor demand and supply. In the short run and long run, the demand and supply for labor is a factor which affects the overall performance of an economy. A highly regulated labor market becomes very inflexible and this reduces the sensitivity of employment to changes in output (Brunner & Meltzer, 1976). In this case, if wages are highly inflexible, it does not adjust easily to bring equilibrium in the demand and supply for labor. It is usually very normal for workers to demand high wages when the prices for goods and services increase in the economy i.e. in the periods of high inflation. This happens because they want to compensate for the gap created through increased prices and maintain their usual levels of consumptions. The biggest problem with this scenario as discussed in the previous pages is that as they demand for more pay rise, firms will react too. The firms will conversely increase prices for goods and services causing an overall increase in the prices (Debreu, 1959). This continues in counter system as inflation climbs higher every time pay rise is approved. However, when the labor market is made inflexible to changes like that of increased prices, it would be very difficult for workers to cause any necessary threats. The free market forces of demand and supply will operate on the rising prices and adjust it to normalcy without further fuelling in inflation (Jossa & Musella, 1998). An automated demand for increased wages by the workers during odd economic shocks can swiftly be controlled by inflexible rules regarding the labor market (Binmore & Dasgupta, 1987). In this case, the relative wage readjustments between different sectors of economy and real wage adjustments during durations of high inflation would be in controlled mode. According to Friedman and Laidler (1975)., inflation can grease the wheels of the labor market by relaxing the downwards effects of labor rigidities. An increase in inflation allows real wage to decrease or fall very fast, but this does not cause any adjustment across all the local labor market. This arises because the inflexible measures within the labor market does not allow for adjustments (Hicks, 1932). As far as these inflexibilities are concerned, they act as shock absorbers to any rise in inflation which might be caused by wages and rise in prices in the economy. According to Keynes and other Keynesian economists, unemployment rises during recessions because the nominal wage rates tend to be inflexible in the downward directions. This occurs because workers will never accept to be paid anything below what they are usually paid. However, the natural way for markets to do away with insufficient demand products such as labor is for the price to fall and this will automatically adjust the supply and demand to a balance (Dixit, 1990). This means that the descending inflexible wages prevents unemployment from occurring rapidly in the event that there is inadequate demand for workers. Labor rigidities are majorly attributed by the following instances in an economy operating under a free market system. The first attribution of such rigidity is the minimum wage rules which ascertain that a specific minimum wage rate cannot be exceeded at any level of the economy (Hicks, 1956). The implication of this is that unemployment and inflation tradeoffs will be guided not to go beyond that minimum limit of wage rate. Most firms may be tempted to lay off some workers as a mode to curb increasing pay demands during periods of economic shocks. The presences of inflexible degree of employment protection will prevent employees from being laid off. This means that output will be almost constant and this is an important variable that take unemployment to its natural rate (Brunner & Meltzer, 1976). Conversely, inflation will be set at normal tradeoff with unemployment. If the labor market is compromised by the bargaining patterns of rules, training and skills will determine the volume of output and growth. The wage rate is set at regulated standards depending on training and skills. This will result to generally increase in growth volume in the economy. Increase in wages will be in direct proportionality with increase in output and this will control the inflation and the unemployment trade off (Friedman & Laidler, 1975). In conclusion, it is very important to note that inflexibilities in the labor market do not only protect the labor market alone. It also controls the shocks in the economy which might be caused by imbalances in aggregate demand. Demands of high wages during such a period, which can further the impact of increased spending is controlled hence a proper mechanism to ensure there is a natural inflation and unemployment trade -off. Inflation of 2% - 3% can make a feasible trade-off with an employment rate of 4%. At this point, ways of stimulating the economy can be rejuvenated and the monetary circumstances can cause some economic growth. Interest rates can then be lowered to induce circulation of liquidity in the system so as to stimulate growth of the whole economy (Brunner & Meltzer, 1976). References Arrow, K. & Hahn, F. 1971, General Competitive Analysis, Holden-Day, San Francisco. Atkinson, T. & Stiglitz, J 1980, Lectures on Public Economics, McGraw-Hill, New York. Binmore, K. & Dasgupta, P 1987, The Economics of Bargaining, Basil Blackwell, Oxford. Brunner, K., & Meltzer, A. H 1976, The Phillips curve and labor markets, North-Holland Publication Company, Amsterdam. Debreu, G 1959, Theory of Value, Willey, New York. Dixit, A 1990, Optimization in Economic Theory (2 ed.), Oxford University Press, Oxford. Friedman, M., & Laidler, D. E 1975, Unemployment versus inflation?: an evaluation of the Phillips Curve, Institute of Economic Affairs, London. Hicks, J 1932, Theory of wages, Macmillan, London. Hicks, J 1956, A Revision of Demand Theory, Oxford University Press, London. Jossa, B., & Musella, M. 1998, Inflation, unemployment, and money: interpretations of the Phillips curve, E. Elgar, Cheltenham, UK. Read More