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Philips Curve It is the short run relationship between inflation and unemployment In 1958, economist A.W.

W. Philips first showed that there is a negative relationship between Inflation and Unemployment. He used data from United Kingdom to make this conclusion. Samuelson and Solow, in 1960 showed a similar relationship using data in US. They attributed this to the fact that low unemployment is linked with high aggregate demand which in turn puts upward pressure on wages and prices throughout the economy. Aggregate Demand, Aggregate supply and Philips curve

Inflation Rate Short run aggregate supply Price Level

High Aggregate Demand Low Aggregate Demand Unemployment

Quantity of Output Supplied

When unemployment decreases i.e. more people are employed aggregate demand increases. As the short run aggregate supply does not change price level shifts up. Thus with decreasing unemployment inflation increases. As monetary and fiscal policy can change the money supply in the market, Government and central bank can shift the aggregate demand to shift the economys price level. Shifts in Philips Curve: The Role of Expectation According to Friedmen and Phelps, on the basis classical theory suggested that monetary policies cannot affect real variables. Therefore in long run there is no trade-off between inflation and unemployment. Growth in money supply will determine price levels and hence inflation, but in long run unemployment remains at its natural rate. Thus long run Philips curve is vertical. Natural Rate of unemployment: It is the employment rate at which economy gravitates in long run. Monetary policies have no control over it. Other policies like job training program, unemployment insurance, collective bargain law, etc. can change the natural rate of unemployment. These policies shift the long run Philips curve to left and increases the output as more number of labour is producing output. This shift the supply curve right. Thus, economy can enjoy more output at reduced level of unemployment and same price levels.

According to sticky wage theory, aggregate supply slope upwards only in short run. Using this, Friedman and Phelps explained that trade-off between inflation and unemployment hold only in short run and not in long run. They introduced a new variable: Expected inflation, how much people expect overall price to change. In short run, expected price level changes nominal wages and short run aggregate supply curve. Thus, when money supply changes aggregate demand shifts and economy moves along short run aggregate supply curve. Monetary changes lead to unexpected fluctuations in output, prices, unemployment and inflation.

Inflation Rate Short run aggregate supply Price Level

High Aggregate Demand Low Aggregate Demand Unemployment

Quantity of Output Supplied

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