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 75: The Long Run Aggregate Supply

 Long Run Aggregate Supply (LRAS):

The Long Run Aggregate Supply (LRAS) represents the total output of goods and services that all firms in an economy are willing and able to produce in the long run when all input prices, including wages, have fully adjusted to changes in the overall price level. It is important to note that the LRAS curve is vertical at the full employment level of output.

Differences between Keynesian and Neo-Classical Views on LRAS:

1. Keynesian View: Keynesian economists argue that the LRAS curve is not necessarily vertical at the full employment level of output. They believe that the economy can have persistent unemployment or output gaps in the long run due to factors like inflexible factor markets, which prevent wages from adjusting quickly to changes in demand and prices.

2. Neo-Classical View: Neo-Classical economists, on the other hand, contend that the LRAS curve is vertical at the full employment level of output. They believe that the economy will tend to reach full employment in the long run as all input prices, including wages, are flexible and can fully adjust to changes in demand and supply.

Neo-Classical View of Long Run Equilibrium:

The Neo-Classical view describes the process through which an economy adjusts to its long-run equilibrium as follows:

1. Flexible Prices and Wages: In the long run, all prices and wages are assumed to be flexible and can adjust freely to changes in demand and supply. This implies that any deviations from the full employment level of output will be temporary, as prices and wages will adjust to restore equilibrium.

2. Self-Correcting Mechanism: If there is an increase in aggregate demand (AD) that pushes the economy beyond the full employment level of output, firms will experience higher demand for their products. They will respond by increasing prices and production, but with fully flexible wages, labor costs will rise in line with prices. As a result, production costs increase, and firms will eventually cut back on hiring and production, moving the economy back towards full employment.

3. Equilibrium at Potential Output: In the Neo-Classical view, the economy will tend to reach its potential output or full employment level in the long run due to the flexibility of prices and wages. This results in a vertical LRAS curve at the full employment level of output.

Keynesian Disagreement with the Neo-Classical View:

Keynesian economists disagree with the Neo-Classical view of long-run adjustment due to factors such as:

1. Inflexible Factor Markets: Keynesians argue that in the short run, factor markets, especially the labor market, may not be flexible enough to adjust quickly to changes in demand and prices. Wages may be "sticky," meaning they do not adjust downward in response to decreased demand, leading to persistent unemployment and deviations from full employment in the long run.

2. Aggregate Demand Management: Keynesian economists advocate for active government intervention through fiscal and monetary policies to manage aggregate demand and stabilize the economy. They believe that relying solely on the self-correcting mechanism of flexible prices and wages may not be sufficient to achieve full employment in the short run.

Assumptions of Flexible Product and Factor Markets:

The Neo-Classical analysis of LRAS is based on the following assumptions:

1. Flexible Prices: All prices, including those of goods and services, can freely adjust to changes in demand and supply conditions.

2. Flexible Wages: Wages can adjust promptly to changes in labor market conditions, ensuring that labor costs align with productivity and prices.

3. Rapid Market Clearing: Markets clear quickly, meaning that any imbalances between demand and supply are corrected swiftly through price and wage adjustments.

Understanding the differences between Keynesian and Neo-Classical views on the LRAS curve and the assumptions underlying each analysis is essential for comprehending the different approaches to macroeconomic policy and the potential implications for economic stability and full employment.

A Level Economics 37: The Short and Long Run in Perfect Competition

In perfect competition, the short run and long run are crucial timeframes for firms to adjust their production levels and optimize their operations. The short run refers to a period where at least one factor of production remains fixed, while the long run is the timeframe where all factors of production can be adjusted.

Adjustment in the Short Run:

In the short run, firms have limited flexibility to change their production capacity since some factors, like plant size and capital equipment, are fixed. However, they can adjust their output levels by varying variable factors, such as labor and raw materials. If market conditions change, firms can respond in the short run by increasing or decreasing their output to align with demand.

1. If demand increases: Firms experience higher prices due to increased demand. In the short run, they can respond by producing more output with existing fixed resources and higher labor utilization.

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3. If demand decreases: Firms face lower prices due to reduced demand. In the short run, they may continue producing at the same level to minimize losses or reduce output slightly, but they cannot fully eliminate the fixed costs.

Adjustment in the Long Run:

In the long run, all factors of production are variable, and firms can fully adjust their production capacity. If firms in the industry are making profits in the short run, new firms are attracted to enter the market. Conversely, if firms are experiencing losses, some may exit the market.

1. Profit in the short run: Existing firms in the industry make economic profits due to high demand and prices. In the long run, these profits signal an incentive for new firms to enter the market, increasing competition.

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3. Losses in the short run: Some firms may incur economic losses due to low demand or high costs. In the long run, these losses act as a signal for firms to exit the market, reducing competition.

In the long run, the entry and exit of firms have a significant impact on the industry's supply and demand dynamics. The market price adjusts to the point where all firms earn normal profits (zero economic profit). Normal profits are sufficient to cover all costs, including opportunity costs of the resources used.

Ultimately, in perfect competition, the short run adjustments, such as changes in output levels, are only temporary solutions to respond to changing market conditions. In the long run, firms fully adjust their production levels, and the market reaches a state of equilibrium where all firms earn normal profits and produce at an optimal level based on consumer demand. The long-run equilibrium reflects a state of allocative and productive efficiency, where resources are optimally allocated, and firms operate at their lowest average total cost.