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.

A Level Economics Essay 22: Phillips Curve

Evaluate the policies that a government could use to shift the long run Phillips curve to the left.

To shift the long-run Phillips curve to the left, which implies achieving lower inflation rates without increasing unemployment, governments can employ various policies. Here are some policy options and their evaluation:

1. Monetary Policy:

   • Tightening Monetary Policy: The government can raise interest rates or reduce the money supply to control inflation. This policy aims to reduce aggregate demand, which can lead to lower inflation rates in the long run. However, it may also have a temporary negative impact on economic growth and employment.

2. Fiscal Policy:

   • Reducing Government Spending: A government can decrease its spending to reduce aggregate demand and put downward pressure on prices. This policy may help in controlling inflation in the long run, but it can also have potential adverse effects on economic activity and employment in the short term.
   • Increasing Taxes: Raising taxes can reduce disposable income and dampen consumer spending, thereby decreasing aggregate demand and inflationary pressures. However, it may have implications for consumer and business sentiment, potentially affecting investment and economic growth.

3. Supply-Side Policies:

   • Structural Reforms: Governments can implement structural reforms to enhance productivity, increase competition, and improve the efficiency of markets. Such reforms can lead to lower costs of production and enhance the economy's potential output, which can help reduce inflationary pressures in the long run.
   • Labor Market Reforms: Policies that aim to increase labor market flexibility and reduce rigidities can improve productivity and promote price stability. For example, reforming employment regulations and facilitating job transitions can help to align wages with productivity levels and reduce the influence of wage inflation.

4. Income and Wage Policies:

   • Wage Restraint: Governments can work with trade unions and employers to promote wage moderation. This approach involves encouraging wage growth to be in line with productivity growth, which can help control labor costs and mitigate inflationary pressures.
   • Income Policies: Governments can implement income policies that address income distribution issues without significantly impacting overall inflation. This can involve targeted social welfare programs or measures to increase income mobility.

Evaluation:

• Effectiveness: The effectiveness of these policies may vary depending on the specific circumstances of an economy. Some policies may have a more immediate impact, while others may require longer-term implementation to yield results.
• Trade-offs: Shifting the long-run Phillips curve to the left often involves trade-offs between inflation and other macroeconomic goals. For example, tighter monetary or fiscal policies may lead to short-term economic slowdown or higher unemployment rates.
• Policy Coordination: It is essential for policies to be coordinated and complementary. Monetary, fiscal, and supply-side policies should work together to achieve desired outcomes and avoid conflicting objectives.
• External Factors: The success of policies may also depend on external factors such as global economic conditions, exchange rates, and international trade. These factors can influence the effectiveness of domestic policies in controlling inflation.

Overall, shifting the long-run Phillips curve to the left requires a combination of appropriate monetary, fiscal, supply-side, and income policies. Governments need to carefully evaluate the potential impact of these policies, considering their effectiveness, trade-offs, coordination, and external factors, to achieve sustainable and stable inflation rates without sacrificing other macroeconomic objectives.

A Level Economics Essay 17: Phillips Curve

Explain, using a diagram or diagrams, why some economists argue that the long run Phillips curve is vertical but that the short run Phillips curve is not.

To understand why some economists argue that the long run Phillips curve is vertical while the short run Phillips curve is not, we need to examine the relationship between inflation and unemployment in both the short run and the long run.

Diagram:

• Horizontal axis: Unemployment rate
• Vertical axis: Inflation rate

1. Short Run Phillips Curve: In the short run, there is a trade-off between inflation and unemployment due to various factors such as nominal wage rigidities, price stickiness, and imperfect information.

The short run Phillips curve is represented by a downward-sloping curve. This implies that as the unemployment rate decreases, inflation tends to rise, and vice versa. The curve shows the inverse relationship between the two variables, indicating that policymakers can influence the unemployment rate through expansionary or contractionary policies that impact inflation.

2. Long Run Phillips Curve: In the long run, economists argue that the Phillips curve becomes vertical, indicating that there is no trade-off between inflation and unemployment. This view is based on the concept of the natural rate of unemployment.

The natural rate of unemployment represents the level of unemployment that exists when the economy is at its potential output in the long run. It is determined by structural factors such as labor market institutions, demographics, and technological changes.

As the economy adjusts over time, wages and prices become more flexible, and any short-run trade-off between inflation and unemployment diminishes. In the long run, the economy returns to the natural rate of unemployment regardless of the level of inflation.

The vertical long run Phillips curve implies that policymakers cannot permanently reduce unemployment through expansionary monetary or fiscal policies. Any attempts to push unemployment below its natural rate would result in higher inflation without any sustained decrease in unemployment.

Therefore, the short run Phillips curve is not vertical because it reflects temporary trade-offs between inflation and unemployment due to nominal rigidities and other factors. In contrast, the long run Phillips curve is vertical because it represents the equilibrium level of unemployment that is consistent with the natural rate and does not change with inflation.

It's important to note that the Phillips curve is a theoretical concept, and the actual relationship between inflation and unemployment can vary over time due to various economic factors, policy interventions, and changes in expectations. Nonetheless, the vertical long run Phillips curve indicates the absence of a permanent trade-off between inflation and unemployment.

Laffer and Phillips curve

 The Laffer curve is used to illustrate the concept of "taxable income elasticity", which is the idea that government can maximize tax revenue by setting tax rates at an optimum point and that neither a 0% tax rate nor a 100% tax rate will generate government revenue.

 The curve is most understandable at both extremes of income taxation—zero percent and one-hundred percent—where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other extreme, where there is a 100% tax rate, the government collects zero revenue because (in a "rational" economic model) taxpayers presumably change their behavior in response to the tax rate: either they have no incentive to work or they avoid paying taxes, so the government collects 100% of nothing.

It however does not mean that a 50 % tax rate maximises the tax revenue.

The Phillips curve is a historical inverse relation between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of change in wages paid to labor in that economy.

Alban William Phillips, a New Zealand-born economist, wrote a paper in 1958 titled The relationship between unemployment and the rate of change of money wages in the United Kingdom 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow took Phillips' work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.
In the 1920s an American economist Irving Fisher noted this kind of Phillips curve relationship. However, Phillips' original curve described the behavior of money wages. So some believe that the Phillips curve should be called the "Fisher curve."
In the years following Phillips' 1958 paper, many economists in the advanced industrial countries believed that his results showed that there was a permanently stable relationship between inflation and unemployment. One implication of this for government policy was that governments could control unemployment and inflation within a Keynesian policy. They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

Stagflation

In the 1970s, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under concerted attack from a group of economists headed by Milton Friedman—arguing that the demonstrable failure of the relationship demanded a return to non-interventionist, free market policies. The idea that there was a simple, predictable, and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists.

[edit] NAIRU and rational expectations

Short-Run Phillips Curve before and after Expansionary Policy, with Long-Run Phillips Curve (NAIRU)

New theories, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. The latter theory, also known as the "natural rate of unemployment", distinguished between the "short-term" Phillips curve and the "long-term" one. The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectations changed. In the long run, only a single rate of unemployment (the NAIRU or "natural" rate) was consistent with a stable inflation rate. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the Nobel Prize in Economics in 2006 for this.
In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by the "Initial Short-Run Phillips Curve" in the graph. Policymakers can therefore reduce the unemployment rate temporarily, moving from point A to point B through expansionary policy. However, according to the NAIRU, exploiting this short-run tradeoff will raise inflation expectations, shifting the short-run curve rightward to the "New Short-Run Phillips Curve" and moving the point of equilibrium from B to C. Thus the reduction in unemployment below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run.
Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for Stagflation, which confounded the traditional Phillips curve.
The rational expectations theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors. This in turn suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would immediately cause inflationary expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU except due to random and transitory mistakes in developing expectations about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.
However, in the 1990s in the U.S., it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actual unemployment rate fell below 4 % of the labor force, much lower than almost all estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.
Further, the concept of rational expectations had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independent of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.

---

Messenger on the move… Text MSN to 63463 now!