Principles of Macroeconomics Study Guide
In this chapter, we trace the history of our understanding of the relationship A.W. Phillips found a negative relationship between inflation and unemployment. In the real world, the relationship is not very precise. But generally, in my humble opinion, a demand pulled inflation (inflation caused due to increase in demand). Review the historical evidence regarding the theory of the Phillips curve The relationship between inflation rates and unemployment rates is inverse.
Back in first-year economics we learned that there is a tradeoff between unemployment and inflation, so you can't really have both low inflation and low unemployment at the same time.Society Faces a Short-run Tradeoff Between Inflation and Unemployment
Do economists still consider that to be true? The Magazine of Economic Justice and is available at http: The trade-off between inflation and unemployment was first reported by A.
Phillips in —and so has been christened the Phillips curve. The simple intuition behind this trade-off is that as unemployment falls, workers are empowered to push for higher wages.
Firms try to pass these higher wage costs on to consumers, resulting in higher prices and an inflationary buildup in the economy.
The trade-off suggested by the Phillips curve implies that policymakers can target low inflation rates or low unemployment, but not both. During the s, monetarists emphasized price stability low inflationwhile Keynesians more often emphasized job creation. The popular textbook of Blanchard gives a textbook presentation of the expectations-augmented Phillips curve. In these macroeconomic models with sticky pricesthere is a positive relation between the rate of inflation and the level of demand, and therefore a negative relation between the rate of inflation and the rate of unemployment.
This relationship is often called the "New Keynesian Phillips curve". Like the expectations-augmented Phillips curve, the New Keynesian Phillips curve implies that increased inflation can lower unemployment temporarily, but cannot lower it permanently. First, there is the traditional or Keynesian version. Then, there is the new Classical version associated with Robert E. The traditional Phillips curve[ edit ] The original Phillips curve literature was not based on the unaided application of economic theory.
Instead, it was based on empirical generalizations. After that, economists tried to develop theories that fit the data. Money wage determination[ edit ] The traditional Phillips curve story starts with a wage Phillips Curve, of the sort described by Phillips himself. This describes the rate of growth of money wages gW. Here and below, the operator g is the equivalent of "the percentage rate of growth of" the variable that follows. However, in the early s, people raised their expectations of inflation and the unemployment rate returned to the natural rate - about five or six percent.
The role of supply shocks The short-run Phillips curve can also shift due to a supply shock. A supply shock is an event that directly alters firms' costs and prices, shifting the economy's aggregate-supply curve and Phillips curve.
A supply shock occurred in when OPEC raised oil prices. This act raised the cost of production and shifted the US short-run aggregate-supply curve to the left, causing prices to rise and output to fall, or stagflation. Rising oil prices also impacted on the Australian economy.
Inflation rose substantially incausing an increase in expected inflation. The rise in actual inflation was fuelled by both rising oil prices and wages.
Since inflation has increased and unemployment has increased, this corresponds to a rightward upward shift in the short-run Phillips curve. Policymakers now face a less favourable trade-off between inflation and unemployment. That is, policymakers must accept a higher inflation rate for each unemployment rate, or a higher unemployment rate for each inflation rate. Also, policymakers now have a difficult choice because, if they reduce aggregate demand to fight inflation, they will further increase unemployment.
If they increase aggregate demand to reduce unemployment, they further increase inflation. The cost of reducing inflation To reduce inflation, the RBA could use a policy of disinflation - a reduction in the rate of inflation.
A reduction in the money supply reduces aggregate demand, reduces production and increases unemployment. This is shown in Exhibit 3 as a movement from point A to point B. Over time, expected inflation falls and the short-run Phillips curve shifts downward and the economy moves from point B to point C.
Phillips curve - Wikipedia
The cost of reducing inflation is a period of unemployment and lost output. The sacrifice ratio is the number of percentage points of annual output that is lost to reduce inflation one percentage point.
The amount of output lost depends on the slope of the Phillips curve and how fast people lower their expectations of inflation.
Some economists estimate the sacrifice ratio to be about five, which is very large.
Supporters of a theory called rational expectations suggest that the cost of disinflation could be much smaller and maybe zero. Rational expectations suggest that people optimally use all available information, including about government policies, when forecasting the future. Thus, an announced policy of disinflation that is credible could move the economy from point A to point C without traveling through point B.