Economics for
Managers
SHUCHIVRAT DESHMUKH
Syllabus
Unit 3:
Phillip's curve: inflation-unemployment trade-off, sacrifice ratio: GDP loss
for unit inflation reduction.
Keynesian overview of macro economy, multiplier, accelerator,
leverage effect
Trade cycles, stagflation, counter-cyclical measures
Outcomes:
• To understand concepts of multiplier and its impact on economic
variables.
• The dilemma between inflation and unemployment with the help of
Philip’s Curve.
• The understanding of trade cycle and its Impact
Inflation
In economics, inflation is defined a sustained increase in the general
price level of goods and services in an economy over a period of
time. It is measured as an annual percentage increase. When the
general price level rises, each unit of currency buys fewer goods
and services.
This implies that inflation reflects a reduction in the purchasing
power per unit of money. In other words, inflation indicates a loss of
real value in the medium of exchange and unit of account in the
economy.
Control of Inflation
Phillips Curve:
The Phillips curve originated out of analysis comparing money
wage growth with unemployment. The findings of A.W. Phillips in The
Relationship between Unemployment and the Rate of Change of
Money Wages in the United Kingdom 1861–1957 suggested there
was an inverse correlation between the rate of change in money
wages and unemployment.
The Phillips Curve represents the inverse relationship between the
rate of inflation and the rate of unemployment. It suggests that
lower unemployment comes with higher inflation, and vice versa.
Long Run Phillips Curve
In the long run, the Phillips Curve is vertical at the natural rate of
unemployment, which is unaffected by inflation.
The long-run Phillips curve implies that the unemployment rate will
always return to the natural rate of unemployment (NAIRU) in the
long run. This means that any attempt to lower unemployment
below the NAIRU will increase inflation.
The long-run Phillips curve suggests that monetary policy can
influence short-term fluctuations in unemployment, but it can't easily
change the long-run unemployment rate. Policymakers need to
look at other government policies to directly influence the NAIRU.
Inflation-Unemployment Trade-Off:
Short-Run Trade-Off: Trade-off exists; policymakers face a dilemma
between inflation and unemployment.
Long-Run Perspective: No trade-off exists; only shifts in inflation
expectations will affect the inflation rate without influencing the
natural rate of unemployment.
Sacrifice Ratio
The sacrifice ratio measures the GDP loss for a unit reduction in
inflation. It is an indicator of the cost associated with reducing
inflation.
Calculation:
Sacrifice Ratio = GDP Loss / Inflation Reduction.
This quantifies how much economic output is sacrificed to reduce
inflation by one percentage point.
Criticisms of Phillips curve
Breakdown During Stagflation: In the 1970s, the Phillips Curve's
validity was challenged by the phenomenon of stagflation, where
high inflation and high unemployment occurred simultaneously. This
contradicted the curve’s prediction of a trade-off between inflation
and unemployment.
Expectations-Augmented Phillips Curve: Economists like Milton
Friedman and Edmund Phelps argued that the Phillips Curve only
holds in the short run. In the long run, inflation expectations adjust,
causing the trade-off between inflation and unemployment to
disappear. This led to the development of the expectations-
augmented Phillips Curve, which incorporates expectations into the
model.
Role of Supply Shocks: The Phillips Curve often fails to account for
supply-side shocks, such as oil price spikes, which can simultaneously
push inflation up and increase unemployment. This was evident
during the 1970s oil crises.
Policy Ineffectiveness: The idea that policymakers can exploit the
Phillips Curve trade-off to reduce unemployment at the cost of
higher inflation has been criticized. Critics argue that such policies
only lead to higher inflation without achieving long-term reductions
in unemployment.
Empirical Instability: The relationship between inflation and
unemployment has not been stable over time. Empirical studies
have shown that the Phillips Curve can shift, with the strength of the
relationship varying across different periods and economic
conditions.
