A Level Economics 76: The Phillips Curve - Short and Long Run

The Short Run Phillips Curve:

The Phillips curve is a graphical representation of the inverse relationship between inflation and unemployment in the short run. It is named after the economist A.W. Phillips, who observed this relationship in the United Kingdom in the 1950s and 1960s. The Phillips curve suggests that when inflation is low, unemployment tends to be high, and vice versa.

The Trade-Off between Inflation and Unemployment in the Short Run:

The trade-off between inflation and unemployment in the short run is often referred to as the "Phillips curve trade-off." This trade-off implies that policymakers can influence inflation and unemployment through demand-side policies. When the economy is experiencing high unemployment, expansionary monetary or fiscal policies can be implemented to stimulate aggregate demand, which in turn reduces unemployment. However, this increase in demand can lead to higher inflation in the short run. Conversely, if the economy faces high inflation, contractionary policies can be used to reduce demand, leading to lower inflation rates but potentially higher unemployment.

Observation of the Trade-Off in the UK:

Historically, the Phillips curve trade-off was observed in the UK during the post-war period and into the 1960s. Policymakers believed that they could exploit this trade-off to achieve both low unemployment and low inflation simultaneously. This relationship appeared to hold true for a time, with periods of low unemployment coinciding with higher inflation and vice versa.

Factors Affecting the Phillips Curve Trade-Off:

1. Expectations: The trade-off between inflation and unemployment can be influenced by the inflation expectations of workers and firms. If individuals expect higher inflation in the future, they may demand higher wages to compensate for the expected loss in purchasing power. This can lead to an increase in costs for businesses, resulting in higher inflation without a significant decrease in unemployment.

2. Supply-Side Shocks: The Phillips curve trade-off can also be affected by supply-side shocks, such as changes in oil prices or other production inputs. Negative supply-side shocks can lead to cost-push inflation, where higher input costs result in higher prices without a corresponding increase in demand.

3. Adaptive Expectations: In the past, policymakers relied on adaptive expectations, assuming that people's expectations about inflation were based on past experiences. However, when people start to anticipate inflation based on current policies, the trade-off may break down, and there could be a shift in the short-run Phillips curve.

The Long Run Phillips Curve:

The Long Run Phillips Curve, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), is a vertical curve that represents the relationship between inflation and unemployment in the long run. Unlike the short-run Phillips curve, which suggests a trade-off between inflation and unemployment, the long-run curve indicates that there is no sustainable trade-off in the long term.

Neo-Classical View on the Short Run Phillips Curve:

Neo-Classical economists argue that the short-run Phillips curve is not stable due to the role of expectations. They believe that in the long run, attempts to hold unemployment below its natural rate (NAIRU) will result in accelerating inflation. Here's the reasoning behind this perspective:

1. Expectations of Inflation: Neo-Classical economists emphasize that inflation expectations play a crucial role in shaping economic behavior. If workers and firms anticipate higher inflation due to expansionary policies aiming to reduce unemployment, they will factor these expectations into wage-setting and price-setting decisions.

2. Adaptive Expectations: Neo-Classical economists often assume that individuals have adaptive expectations, meaning their expectations of inflation are based on past experiences. If policymakers attempt to maintain low unemployment by implementing demand-side policies, this could lead to unexpected increases in inflation.

3. Time Inconsistency: Another issue that arises is the problem of time inconsistency in policymaking. Policymakers may prioritize reducing unemployment in the short run, but when inflation starts to accelerate, they may be forced to tighten monetary or fiscal policies to control inflation, leading to a higher unemployment rate in the long run.

Long Run Equilibrium:

In the long run, the economy tends to return to its natural rate of unemployment (NAIRU) regardless of the level of inflation. As workers and firms adapt their expectations to reflect actual inflation levels, wages and prices adjust accordingly. This leads to a situation where attempts to keep unemployment below its natural rate will only result in accelerating inflation without achieving a sustained reduction in unemployment.

Supply-Side Changes and Long Run Phillips Curve Shifts:

Changes on the supply side of the economy can cause shifts in the position of the long-run Phillips curve. Favorable supply-side changes, such as improvements in productivity or technological advancements, can lead to a lower natural rate of unemployment (NAIRU). Conversely, adverse supply-side shocks, like increases in oil prices or disruptions to production, can raise the NAIRU.

Role of Inflationary Expectations:

Inflationary expectations play a critical role in the long-run Phillips curve model. If individuals and businesses expect higher inflation, they will act accordingly by demanding higher wages and setting higher prices, leading to an increase in actual inflation. This reinforces the notion that inflation expectations are self-fulfilling in the long run.

Conclusion:

Neo-Classical economists argue that the short-run Phillips curve is not stable, and there is no sustainable trade-off between inflation and unemployment in the long run. Attempts to hold unemployment below its natural rate through demand-side policies may result in accelerating inflation. Supply-side changes can shift the position of the long-run Phillips curve, and inflationary expectations play a vital role in influencing actual inflation rates over time. Understanding these dynamics is essential for formulating effective economic policies that target both inflation and unemployment in the long term.

Economics Essay 56: Evaluating NAIRU

“It is possible to reduce the natural rate of unemployment/NAIRU but not possible to reduce unemployment below the natural rate/NAIRU.” Evaluate this statement.

The natural rate of unemployment, also known as the non-accelerating inflation rate of unemployment (NAIRU), refers to the level of unemployment that exists in an economy when it is in a state of equilibrium, with stable inflation and no cyclical fluctuations. It represents the unemployment rate that is consistent with the economy's long-term potential output and does not contribute to accelerating inflation.

The statement suggests that while it is possible to reduce the natural rate of unemployment (NAIRU), it is not possible to reduce unemployment below the natural rate. Let's evaluate this statement:

1. Reducing the Natural Rate of Unemployment/NAIRU: It is theoretically possible to lower the natural rate of unemployment through various policy measures. These measures include improving education and skills training programs, implementing labor market reforms, promoting investment in technology and infrastructure, and fostering an environment conducive to entrepreneurship and innovation. By addressing structural issues in the economy, such as mismatched skills and inefficient labor market dynamics, the natural rate of unemployment can be reduced. This can lead to higher levels of employment and a more efficient allocation of labor resources.

2. Reducing Unemployment Below the Natural Rate/NAIRU: It is generally believed that it is not possible to sustainably reduce unemployment below the natural rate/NAIRU in the long run. This is because attempting to push unemployment below its natural rate through expansionary policies, such as excessive fiscal stimulus or monetary easing, can lead to inflationary pressures. When the economy operates below its natural rate of unemployment, labor markets become tighter, and competition for workers increases. As a result, wages rise, leading to higher production costs for businesses. In order to maintain their profit margins, firms may pass on these increased costs to consumers through higher prices, thereby fueling inflation. Central banks may then need to tighten monetary policy to curb inflation, which could lead to a slowdown in economic activity and potentially higher unemployment.

In summary, while it is possible to reduce the natural rate of unemployment/NAIRU through structural reforms and policy measures, sustaining unemployment levels below the natural rate in the long run is challenging. Attempting to do so may lead to inflationary pressures and potentially negative economic consequences. Policymakers often focus on creating an environment that fosters job creation, reduces barriers to employment, and improves labor market dynamics, aiming to bring the actual unemployment rate closer to the natural rate/NAIRU without risking destabilizing inflation.