Phillips Curve:

Short run and Long run

 Introduction
In the simple Keynesian model of an economy, the AS curve is a horizontal straight line
up to the full-employment level of output.
This means that during recession or depression when the economy is having a good deal
of excess capacity and large-scale unemployment of labour and idle capital stock, the AS
curve is perfectly elastic.
When full-employment level of output is reached, AS curve becomes perfectly inelastic.
Increase in AD before the level of full employment, causes increase in the level of real
national output and employment with price level remaining unchanged.
Simple Keynesian model with inverse L-shaped AS curve there is no trade-off or clash
between inflation and unemployment.
 Inflation-unemployment Trade-off:
Phillips Curve
However, the actual empirical evidence did not fit well in the above simple Keynesian
macro model.

A noted British economist, A.W. Phillips, published an article in 1958 based on his good
deal of research using historical data from the U.K. for about 100 years in which he
arrived at the conclusion that there existed an inverse relationship between rate of
unemployment and rate of inflation.

The Phillips curve examines the relationship between the rate of unemployment and
the rate of money wage changes.
 Phillips Curve
Phillips derived the empirical relationship that when unemployment is high,
the rate of increase in money wage rates is low.

This is because “workers are reluctant to offer their services at less than the
prevailing rates when the demand for labour is low and unemployment is
high so that wage rates fall very slowly.”

On the other hand, when unemployment is low, the rate of increase in

money wage rates is high.

This is because, “when the demand for labour is high and there are very few
unemployed we should expect employers to bid wage rates up quite rapidly.”
 Phillips Curve
Several economists have extended the Phillips curve analysis to the tradeoff between
the rate of unemployment and the rate of change in the level of prices or inflation rate
by assuming that prices would change whenever wages rose more rapidly than labour
productivity.

If the rate of increase in money wage rates is higher than the growth rate of labour
productivity, prices will rise and vice versa.

This inverse relation implies a trade-off, that is, for reducing unemployment, price in
the form of a higher rate of inflation has to be paid, and for reducing the rate of
inflation, price in terms of a higher rate of unemployment has to be borne.
Phillips obtained a downward sloping curve
exhibiting the inverse relation between rate
of inflation and the rate of unemployment
and this curve is now named after his name
as Phillips Curve.
 Policy Implication & Stagflation

This trade-off presents a dilemma for the policy makers; should they choose a higher
rate of inflation with lower unemployment or a higher rate of unemployment with a
low inflation rate.

During 70’s a strange phenomenon was witnessed in the US and Britain when there
existed a high rate of inflation side by high unemployment rate.

This was contrary to both Phillips curve concept and the simple Keynesian model.

This simultaneous existence of both high rate of inflation and high unemployment rate
or low level of real national product during the seventies and early eighties has
been described as stagflation.
 Causes of Shift in Phillips Curve
There are two explanations for this.
First, according to Keynesians, It was due to the adverse supply shocks in the form of
fourfold increase in the prices of oil and petroleum products delivered to the American
economy 1973-74 and 79-80.

The hike in price of oil by OPEC, brought about

a rise in the cost of production of several
commodities for the production.

Further, the oil price hike also raised the

transportation costs of all commodities. The
increase in cost of production and
transportation of commodities caused a shift
in the aggregate supply curve upward to the
left.
Long-run Phillips Curve: Friedman’s View

Economists have criticized and in certain cases modified the Phillips curve.

They argue that the Phillips curve relates to the short run and it does not remain stable.

It shifts with changes in expectations of inflation.

In the long run, there is no trade-off between inflation and unemployment.

These views have been expounded by Friedman and Phelps in what has come to be
known as the “accelerationist” or the “adaptive expectations” hypothesis.
Long-run Phillips Curve: Friedman’s View
According to Friedman, there is no need to assume a stable downward sloping Phillips
curve to explain the trade-off between inflation and unemployment.

In fact, this relation is a short-run phenomenon. But there are certain variables which
cause the Phillips curve to shift over time and the most important of them is the
expected rate of inflation.

So long as there is discrepancy between the expected rate and the actual rate of
inflation, the downward sloping Phillips curve will be found.

But when this discrepancy is removed over the long run, the Phillips curve becomes
vertical.
 Natural Rate of Unemployment
Friedman introduces the concept of the natural rate of unemployment.

In represents the rate of unemployment at which the economy normally settles because
of its structural imperfections.
It is the unemployment rate below which the inflation rate increases, and above which the
inflation rate decreases.

At this rate, there is neither a tendency for the inflation rate to increase or decrease.

Thus the natural rate of unemployment is defined as the rate of unemployment at which
the actual rate of inflation equals the expected rate of inflation.

It is thus an equilibrium rate of unemployment toward which the economy moves in

the long run.

In the long run, the Phillips curve is a vertical line at the natural rate of unemployment
 Natural Rate of Unemployment

The natural rate of unemployment is the rate at which in the labour market
the current number of unemployed is equal to the number of jobs available.

These unemployed workers are not employed for the frictional and
structural reasons, though the equivalent number of jobs are available for
them.
 Natural Rate of Unemployment
This natural or equilibrium unemployment rate is not fixed for all times.

Rather, it is determined by a number of structural characteristics of the labour and

commodity markets within the economy.

These may be minimum wage laws, inadequate employment information,

deficiencies in manpower training, costs of labour mobility, and other market
imperfections.

But what causes the Phillips curve to shift over time is the expected rate of inflation.

This refers to the extent the labour correctly forecasts inflation and can adjust wages
to the forecast.
 Adaptive Expectation
Expectations about the future rate of inflation play a critical role

Adaptive expectations – people form their expectations on the basis of previous period
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.
Suppose the economy is experiencing a mild rate of
inflation of 2% and a NRU (N) of 3%. At point A on
the short run Phillips curve SPC1, people expect
this rate of inflation to continue in the future.

Now assume that the govt. adopts a monetary-

fiscal programme to raise AD in order to lower
unemployment from 3 to 2%.

The increase in AD will raise the rate of inflation to

4% consistent with the unemployment rate of 2%.

When the actual inflation rate (4%) is greater than

the expected inflation rate (2%), the economy
moves from point A to B along the SPC1 curve and
the unemployment rate temporarily falls to 2%.
This is achieved because the labour has been
deceived.
But the workers eventually begin to realise that the
actual rate of inflation is 4% which now becomes their
expected rate of inflation.

Once this happens the short-run Phillips curve SPC1

shifts to the right to SPC2. Now workers demand
increase in money wages to meet the higher expected
rate of inflation of 4%.

They demand higher wages because they consider the

present money wages to be inadequate in real terms.

As a result, real labour costs will rise, firms will

discharge workers and unemployment will rise
from B (2%) to C (3%) with the shifting of the SPC1
curve to SPC2.

At point C, the NRU is re-established at a higher rate

of both the actual and expected inflation (4%).
If the govt. is determined to maintain the level of
unemployment at 2%, it can do so only at the cost of
higher rates of inflation.

From point C, unemployment reduced to 2% via increase

in AD along the SPC2 curve until we arrive at point D.

With 2% unemployment and 6% inflation at point D, the

expected rate of inflation for workers is 4%.

As soon as they adjust their expectations to the new

situation of 6% inflation, the short-run Phillips curve shifts
up again to SPC3, and the unemployment will rise back to
its natural level of 3% at point E.

If points A, C and E are connected, they trace out a vertical

long-run Phillips curve LPC at the natural rate of
unemployment. On this curve, there is no trade-off
between unemployment and inflation.
 Adaptive Expectation

According to this hypothesis, the expected rate of inflation always lags behind the
actual rate.

But if the actual rate remains constant, the expected rate would ultimately become
equal to it.

This leads to the conclusion that a short-run trade off exists between unemployment
and inflation, but there is no long run trade-off between the two unless a
continuously rising inflation rate is tolerated.
 Philip curve & Rational Expectations Theory

In the Friedman-Phelps acceleration hypothesis of the Phillips curve, there is a short-run

trade-off between unemployment and inflation but no longrun trade-off exists.

The reason is that inflationary expectations are based on past behaviour of inflation which
cannot be predicted accurately.

Therefore, there is always an observed error so that the expected rate of inflation always
lags behind the actual rate.
Philip curve & Rational Expectations Theory

Developed by new classical macroeconomics

Economists belonging to the rational expectations (Ratex) school have denied the
possibility of any trade-off between inflation and unemployment even during the longrun.

According to them, the assumption implicit in Friedman’s version that price expectations
are formed mainly on the basis of the experience of past inflation is unrealistic.

When people base their price expectations on this assumption, they are irrational. If they
think like this during a period of rising prices, they will find that they were wrong.

But rational people will not commit this mistake. Rather, they will use all available
information to forecast future inflation more accurately.
 Rational Expectations Theory
The idea of rational expectations was first put forth by Johy Muth in 1961.

Muth pointed out that certain expectations are rational in the sense that expectations
and events differ only by a random forecast error.

It did not convince many economists and lay dormant for ten years.

It was in early 1970s that Robert Lucas, Thomas Sargent and Neil Wallace applied
the idea to problems of macroeconomic policy.

The Ratex hypothesis - economic agents form expectations of the future values of
economic variables by using all the economic information available to them.

They assume that economic agents have full and accurate information about future
economic events.
Cont.

The advocates of this theory - nominal wages are quickly adjusted to any expected
changes in the price level so that there does not exist the type of Phillips curve that shows
trade-off between rates of inflation and unemployment.

As a result of increase in AD, there is no reduction in unemployment rate.

The rate of inflation resulting from increase in AD 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.
 Rational expectations theory rests on two basic elements

1. Workers and producers being quite rational have a correct understanding of the economy
and therefore correctly anticipate the effects of the Govt.’s economic policies using all the
available relevant information. On the basis of these anticipations of the effects of
economic events and Govt.’s policies they take correct decisions to promote their own
interests.

2. Like the classical economists, it assumes that all product and factor markets are highly
competitive. As a result, wages and product prices are highly flexible and therefore can
quickly change upward and downward.
The people’s expectations of inflation and acting upon them in their decision making
when expansionary monetary policy is adopted nullify the intended effect (that is,
increase in real output and employment) of Government’s monetary policy.

The intended effect of expansionary monetary policy on investment, real output and
employment does not materialize.

It is due to the anticipation of inflation by the people and quick upward adjustment
made in wages, interest etc., by them that the price level instantly rises.

That is why, according to the ratex theory, AS curve is a vertical straight line.

The vertical AS curve means that there is no trade-off between inflation and
unemployment, that is, downward sloping Phillip curve does not exist.