PHILLIPS CURVE & AS CURVE
The Phillips Curve
A.W. Phillips found that unemployment was negatively related to wage growth in the United Kingdom.
Other economists have found this same negative relationship in many other countries.
The intuition behind this relationship is a strong economy increases labor demand, which pushes up
nominal wages and reduces unemployment. The higher wages raise firms’ costs, which encourages
those firms to raise their prices.
Since inflation rises with nominal wage growth and inflation is a key macroeconomic variable,
economists focus on the negative relationship between unemployment and inflation, which is known as
the Phillips curve.
The Phillips curve also predicted that the economy will always come back to the natural rate of
unemployment, due to flexibility in wages and prices.
Since Phillips curve shows a trade-off between inflation and unemployment rate, any attempt to solve
the problem of inflation will lead to an increase in the unemployment. Similarly, any attempt to
decrease unemployment will aggravate inflation. Thus, the negative sloped Phillips Curve suggested that
the policy makers in the short run could choose different combinations of unemployment and inflation
rates.
The Phillips Curve during the 1960s
U.S. data from 1950-1969 supports the Phillips curve claim that unemployment and inflation are
negatively related.
Okun’s Law
1. Okun’s law says that for every one percentage point the unemployment rate is above its natural rate,
output is two percentage points below its potential Y – Y* = – 2 (U – U*)
Y*
Sacrifice Ratio
It is the percentage of annual output lost in reducing inflation by 1%
The Phillips Curve after the 1960s
The negative relationship between unemployment and inflation disappears after 1970 in U.S.- high
inflation and high unemployment.(stagflation was experienced)
Inflation did not decrease unemployment because workers understood that as inflation increases or
prices increase, their wages are not rising proportionally, hence they decrease their supply and hence
they get back to the original unemployment level, just at a higher inflation now.
The Friedman-Phelps Analysis of the Phillips Curve
When inflation rises, workers do not want their real wages to fall, so nominal wage growth moves one-
forone with the inflation rate, real wage being constant – which is the case for the long run phillips
curve. Workers will increase their supply only when their real wages will rise
In the long run, the unemployment rate (U) is at the natural rate of unemployment (U*), which is
independent of the inflation rate.
Friedman-Phelps critique suggests that the short run Phillips curve can be written as follows:
Gw = πe – ε(U – U*) + v
(1) where πe is expected inflation, v is the supply shock variable
(2) real wage will be constant when actual inflation is equal to expected inflation
(3) unemployment is at the natural rate when actual = expected inflation
(4) the position of the SR curve depends on expected inflation and the supply shock variable
Theory of Adaptive Expectations and Natural Rate Hypothesis:
Friedman’s explanation of shift in the short-run Phillips curve is that expectations about the future rate
of inflation play an important role in it. Friedman put forward a theory of adaptive expectations
according to which people form their expectations on the basis of previous and present rate of inflation,
and change or adapt their expectations only when the actual inflation turns out to be different from
their expected rate.
According to this Friedman’s theory of adaptive expectations, there may be a trade-off between rates of
inflation and unemployment in the short run, but there is no such trade-off in the long run. The view of
Friedman and his follower monetarists is illustrated in Figure 21.6.
To begin with SPC1 is the short-run Phillips curve and the economy is at point A0, on it corresponding to
the natural rate of unemployment equal to 5 per cent of labour force. The location of this point A0 on
the short-run Phillips curve depends on the level of aggregate demand.
Further, we assume that the economy is currently experiencing a rate of inflation equal to 5%. The other
assumption we make is that nominal wages have been set on the expectations that 5 per cent rate of
inflation will continue in the future.
Now, suppose for some reasons the government adopts expansionary fiscal and monetary policies to
raise aggregate demand. The consequent increase in aggregate demand will cause the rate of inflation
to rise, say to seven per cent. Given the level of money wage rate which was fixed on the basis that the 5
per cent rate of inflation would continue to occur, the higher price level than expected would raise the
profits of the firms which will induce the firms to increase their output and employ more labour.
As a result of the increase in aggregate demand resulting in a higher rate of inflation and more output
and employment, the economy will move to point A1 on the short- run Phillips curve SPC1 in Figure
21.6, where unemployment has decreased to 3.5 per cent while inflation rate has risen to 7%.
It may be noted from Figure 21.6 that in moving from point A0 to A1, on SPC1 the economy accepts a
higher rate of inflation at the cost of achieving a lower rate of unemployment. Thus, this is in conformity
with the concept of Phillips curve explained earlier.
Long-Run Phillips Curve and Adaptive Expectations:
This brings us to the concept of long-run Phillips curve, which Friedman and other natural rate theorists
have put forward. According to them, the economy will not remain in a stable equilibrium position at
A1. This is because the workers will realize that due to the higher rate of inflation than the expected
one, their real wages and incomes have fallen.
The workers will therefore demand higher nominal wages to restore their real income. But as nominal
wages rise to compensate for the higher rate of inflation than expected, profits of business firms will fall
to their earlier levels. This reduction in their profit implies that the original motivation that prompted
them to expand output and increase employment resulting in lower unemployment rate will no longer
be there.
Consequently, they will reduce employment till the unemployment rate rises to the natural level of 5%.
That is, with the increase is nominal wages in Figure 21.6 the economy will move from A1 to B0, at a
higher inflation rate of 7%. It may be noted that the higher level of aggregate demand which generated
inflation rate of 7% and caused the economy to shift from A0 to A1 still persist.
Further, at point B0, and with the actual present rate of inflation equal to 7 per cent, the workers will
now expect this 7 per cent inflation rate to continue in future. As a result, the short-run Phillips curve
SPC shifts upward from SPC1 to SPC2. It therefore follows, according to Friedman and other natural rate
theorists, that the movement along a Phillips curve SPC is only a temporary or short-run phenomenon.
In the long when nominal wages are fully adjusted to the changes in the inflation rate and consequently
unemployment rate comes back to its natural level, a new short-run Phillips curve is formed at the
higher expected rate of inflation.
It is important to remember that adaptive expectations theory has also been applied to explain the
reverse process of disinflation, that is, fall in the rate of inflation as well as inflation itself. Suppose in
Figure 21.6 the economy is originally at point C0 with 9% rate of inflation.
Now, if a decline in aggregate demand occurs, say as a result of contraction of money supply by the
Central Bank of a country, this will reduce inflation rate below the 9 per cent expected rate. As a result,
profits of business firms will decline because the prices will be falling more rapidly than wages. The
decline in profits will cause the firms to reduce employment and consequently unemployment rate will
rise.
Eventually, firms and workers will adjust their expectations and the unemployment rate will return to
the natural rate. The process will be repeated and the economy in the long run will slide down along the
vertical long-run Phillips curve showing falling rate of inflation at the given natural rate of
unemployment.
It follows from above that according to adaptive expectations theory any rate of inflation can occur in
the long run with the natural rate of unemployment.
Long-Run Phillips Curve: Rational Expectations Theory:
Friedman’s adaptive expectations theory assumes that nominal wages lag behind changes in the price
level.This lag in the adjustment of nominal wages to the price level brings about rise in business profits
which induces the firms to expand output and employment in the short run and leads to the reduction
in unemployment rate below the natural rate. According to the rational expectations theory, which is
another version of natural unemployment rate theory, there is no lag in the adjustment of nominal
wages consequent to the rise in price level.
The advocates of this theory further argue that nominal wages are quickly adjusted to any expected
changes in the price level so that there does not exist Phillips curve showing trade-off between rates of
inflation and unemployment. According to them, as a result of increase in aggregate demand, there is no
reduction in unemployment rate.
The rate of inflation resulting from increase in aggregate demand is fully and correctly anticipated by
workers and business firms and get completely and quickly incorporated into the wage agreements
resulting in higher prices of products.
Thus, it is the price level that rises, the level of real output and employment remaining unchanged at the
natural level. Hence, aggregate supply curve according to the rational expectations theory is a vertical
straight line at the full-employment level.
NAIRU - The non-accelerating inflation rate of unemployment
The non-accelerating inflation rate of unemployment (NAIRU) is the specific level of unemployment that
is evident in an economy that does not cause inflation to increase nor decrease. When unemployment is
at the NAIRU level, inflation is steady; when unemployment rises above NAIRU, inflation decreases;
when unemployment drops below NAIRU, inflation increases.
NAIRU was first introduced in 1975 as the noninflationary rate of unemployment (NIRU) by Franco
Modigliani and Lucas Papademos. It was an improvement of the concept of the "natural rate of
unemployment" by Milton Friedman.
The theory states that if the actual unemployment rate is less than the NAIRU level for a few years,
inflationary expectations rise, so the inflation rate tends to increase. If the actual unemployment rate is
higher than the NAIRU level, inflationary expectations fall so the inflation rate decreases. If both the
unemployment rate and the NAIRU level are equal, the inflation rate remains constant.
The NAIRU and Natural rate of unemployment are similar concepts – they both reflect the level of
structural unemployment when the economy is close to full employment. However, they have different
compositions and can vary in the short term. The natural rate of unemployment is determined by
structural unemployment, e.g. mismatch of skills, frictional unemployment and geographical immobility.
Like the NAIRU, the Natural rate of unemployment (NR) is shown by the vertical Phillips Curve. And both
the NR and the NAIRU will tend to converge to the same level. They are much steadier than the headline
unemployment rate – which can vary due to fluctuations in the economic cycle. However, in the short-
term the NAIRU is likely to be more volatile; this is because the non-accelerating inflation rate of
unemployment can change due to short-term factors, such as wage inflation, changes in wage
expectations. For example, in a recession, when unemployment rises, inflation expectations may be
slow to adjust, so a rise in demand can enable lower unemployment with no effect on inflation.
Note: There are limitations associated with NAIRU. It is a study of the historical relationship between
unemployment and inflation and represents the specific level of unemployment before prices tend to
rise or fall. However, in the real world, the historical correlation between inflation and unemployment
can break down. Also, many factors impact unemployment besides inflation. For example, workers who
lack the skills needed to get a job would likely face unemployment, while the workers who have the
skills are likely to be employed. One of the challenges lies in estimating the NAIRU level for different
groups of workers who have different skill sets.
Hysteresis Effects
In economics, hysteresis consists of effects that persist after the initial causes giving rise to the effects
are removed. Two of the main areas in economics where hysteresis effects are invoked to explain
economic phenomena are unemployment and international trade. In macroeconomics or labour
economics, hysteresis states that historical rates of unemployment are likely to influence the current
and future rates of unemployment. If there is a recession and rise in cyclical unemployment, this
temporary unemployment can affect the underlying structural rate and increase the natural rate of
unemployment or the NAIRU. This phenomenon can make unemployment a lagging factor.
According to Blanchard and Summers (1996), proponents of hysteresis, recessions can have a
permanent impact if they change the characteristics or attitude of those who lost their jobs as a result of
recessions. A worker who was temporarily unemployed due to cyclical factors may find over time, he
becomes structurally unemployed. From the temporary rise in unemployment, we get a higher natural
rate of unemployment (NAIRU). Another reason for possible hysteresis is in sticky wages. If a worker
loses his job, he becomes an outsider and is unable to influence wages. The remaining workers manage
to prevent cuts in nominal wages, and so real wages don’t fall to retain equilibrium wage rates.
There may be other kinds of hysteresis effects with regards to inflation. In particular, high inflation
influences inflationary expectations and so high inflation tends to cause high inflation in the future.
Similarly, low inflation tends to cause low inflation.
Supply Shocks
Shocks are events that are by and large unexpected and bring out changes in real economic growth,
inflation and unemployment. According to contemporary economic theory, a supply shock creates a
material shift in the aggregate supply curve and forces prices to scramble towards a new equilibrium
level.
In the short run, an economy-wide negative supply shock will shift the aggregate supply curve leftward,
decreasing the output and increasing the price level (see figure below). This kind of supply shock can
cause stagflation due to a combination of rising prices and falling output. In the short run, an economy-
wide positive supply shock will shift the aggregate supply curve rightward, increasing output and
decreasing the price level. A positive supply shock could be an advance in technology (a technology
shock) which makes production more efficient, thus increasing output.
JNU Questions
SIS Papers SSS Papers
2017 – 9 2017 – 33
2016 – 23 2015 – 48
2015 – 2,3,6 2013 – 37
2014 – 16,18-19, 2011 –16-22
2013 – 16,17 2010 – 2
2012 – 19-20 2009 –A9
2008 –5 2008 – B7
2004 – 1(a) 2006 – 19
