What is the Philips Curve? Explain why critics believe the relationship no longer holds.
Different macroeconomic policies can be implemented in order to achieve government’s main objectives of full employment and stable economy through low inflation. Philips Curve can be use as a tool to explain the trade-off between these two objectives. This essay will first explain the Philips Curve and its relation to inflation and unemployment. Then, the breakdown of Philips Curve will be analysed. Followed by an evaluation of short-run and long-run Philips Curve. Finally, it considers whether the Philips Curve still exists and is therefore relevant to policy makers.
Philips Curve illustrates the relationship between inflation and unemployment in an economy. Inflation is a sustained increase in the average price of goods over time. When there is inflation, value of money falls. In the UK it is mainly measured through retail price index. A low inflation rate indicates that average price of goods would not rise as high. Furthermore, unemployment exist when someone are available and actively seeking for work but unable to find any despite their willingness to accept the going wage rate.
The economist A.W Philips that was first put this theory forward in 1958 gathered the data of unemployment and changes in wage levels in the UK from 1861 to 1957. From the observation, he found that one stable curve represented the trade-off between inflation and unemployment. In other words, if unemployment increases, inflation will decrease, and vice versa.
Fig.1 The original Philips Curve: wage inflation against unemployment
Source: Griffiths and Wall, p.514
The downward sloping Curve in fig.1 shows that, in theory, there is an inverse relationship between inflation and unemployment. For example, after the economy has just been in recession, the unemployment level will be fairly high. This will mean that there is a labour surplus. As the economy grows, the aggregate demand (AD) will increase and therefore leading to an increase in employment. In the beginning, there will be little pressure for a raise in wages. However, as the economy grows faster and more people are employed, wages will slowly rise. This will increase the firm’s cost of production and the high costs are usually passed on to the customers in a form of higher prices. Therefore a decrease in unemployment has led to an increase in inflation and vice versa. Moreover, unemployed might suffer from money illusion as they thought the increase in wages offered to them represented a real wage (Sloman 2000). They underestimate inflation by not realizing that higher wages will be eaten up by higher prices. Thus they will accept job more readily and this will reduce the frictional unemployment in the short run.
Keynesian demand management approach was fashionable in the UK government policies from 1945 up to mid 1970 (Sloman, 2000). It believes that business cycle is being driven by aggregate demand shocks and it encourages active government intervention in the economy. The theory suggest that policy makers can either expand AD in order to lower unemployment in the short term at the cost of higher inflation, or they can contract AD in an attempt to lower inflation at the cost of higher unemployment. Trade-off between inflation and unemployment can be seen as the core of Keynesian theory. This idea was empirically justified in the Philips Curve relationship between the wage rate or inflation rate and the unemployment rate. Furthermore, Keynesian suggests that government can decide how much extra inflation to accept in order to bring the unemployment down. This can be done by choosing a point in the Philips Curve and set fiscal or monetary policies to achieve the desired level of AD and thus unemployment level.
Using the data from the 1950s...
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