Increase in AD can
be due to a fiscal or
monetary policy,
thus increasing
prices
Cost push:
4% 6% Unemployment (%)
PC1
The curve crosses the horizontal axis at a positive
value of unemployment. Hence it is not possible to
have zero inflation and zero unemployment
The concave shape implies that lower the level of
unemployment higher the rate of inflation.
Govt. should be able to use demand management
policies to take the economy to acceptable levels of
inflation and unemployment.
In order to achieve full employment, some inflation is
unavoidable.
However, this relationship broke down at the end of
1960s when Britain began to experience rising
inflation and unemployment.
This raised a question on the application of Phillips
curve in the long run.
Long run Phillips curve:
dp/dt = f(1/u) + dpe/dt
To keep unemployment below the natural
rate, inflation must keep on increasing every
year. In the long run Philips curve will be
vertical at the rate of unemployment where
real aggregate demand equals real aggregate
supply. This rate is called the natural rate of
unemployment. It is also called NAIRU or
Lowest sustainable unemployment rate
(LSUR).
The Philips Curve
To counter the rise in unemployment,
Long Run PC government once again injects resources
into the economy – the result is a short-
inflation term
There
Assume fall
is ineconomy
athe
shortunemployment
term fallstarts but
in unemployment
with an higher
inflation
butrate
at aof
cost
1% of
buthigher
very high
inflation.
unemployment
Individuals at now
7%.base their
inflation. This higher inflation fuels further
wage
Government
negotiations
takeson measures
expectationsto reduce
of higher inflation
expectation
inunemployment
the next period. of higher
byIfan
higher inflation
expansionary
wages arefiscaland
granted so
policy the
then
process
firms
that costs
pushes continues.
rise
AD– to
they
thestartThe
rightto(seelong
shedthe runand
labour
AD/AS Phillips
unemployment
diagram on slide creeps
15) back up to 7% again.
Curve is vertical at the natural rate of
3.0% unemployment. This is how economists
have explained the movements in the
Phillips Curve and it is termed the
Expectations Augmented Phillips
Curve.
2.0%
1.0%
PC1
7% PC2 Unemployment
PC3
7% becomes the natural rate in this
case.
Whenever unemployment rate is
pushed below natural rate , wages
increase, pushing up costs. This leads
to a lower level of output which pushes
unemployment back to the natural
rate.
Countering inflation:
Demand -pull Reduce demand by higher taxation, lower govt.
expenditure, lower govt borrowing, higher interest
rates