What does the Phillips curve signify? How do you reconcile the difference in the shape of the
curve in the short run and the long run?
The Phillips curve shows the relationship between unemployment and inflation in an economy. Since its ‘discovery’ by British economist AW Phillips, it has become an essential tool to analyse macro-economic policy.
The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses:
An increase in the demand for labour as government spending generates growth.
The pool of unemployed will fall.
Firms must compete for fewer workers by raising nominal wages.
Workers have greater bargaining power to seek out increases in nominal wages.
Wage costs will rise.
Faced with rising wage costs, firms pass on these cost increases in higher prices.
it appeared that the Phillips Curve trade off no longer existed - there no longer seemed a stable pattern. The stable relationship between unemployment and inflation appeared to have broken down. It was possible to have a number of inflation rates for any given unemployment rate.
American economists Friedman and Phelps offered one explanation - namely that there is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run, there is no trade-off between unemployment and inflation.
Although there are disagreements between new-Classical economists andmonetarists, the general line of argument about the breakdown of the Phillips curve runs as follows.
Assume that the economy starts from an equilibrium position at point A, with inflation currently at zero, and unemployment at the natural rate of 10% (NRU = 10%). Secondly, given the public’s concern with unemployment, assume the government attempts to expand the economy quickly by way of a fiscal (or monetary) stimulus, so that AD increases and unemployment falls.
Initially, the economy moves to B, and there is a fall in unemployment to 3% (at U1) as jobs are created in the short term. Having more bargaining power, workers bid-up their nominal
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