What is the Philips Curve

What is the Philips Curve? Explain why critics believe the relationship no longer holds.

The Phillips curve describes a negative relationship between rising prices and unemployment. In this essay I will sketch the beginnings and development of the Phillips curve, and the expostulations against it. These aims take different point of views, both theoretical and empirical, and some are addressed by the refined expectations-augmented curve that I shall briefly lineation. The decision I intend to show is that the Phillips curve, though surely non without defects, has usage in short-run analysis.

The Phillips curve was developed in 1958 by A W Phillips. He observed an empirical regularity between rising prices and unemployment, detecting that the two variables were systematically negatively correlated. The relationship is of involvement for several grounds. The first of these is that rising prices and unemployment are both often the marks of economic policy shapers. As such, a relationship ( or tradeoff ) between the two has of import deductions when make up one’s minding pecuniary and financial policies. Additionally, rising prices is a nominal variable, while unemployment is a existent variable and it is a commonly-held position that nominal variables can non hold enduring effects on existent 1s. Finally, at its clip of construct, the Phillips curve was the consequence of empirical observation, and no theoretical footing for it existed ( one of the chief points cited by its critics ) .

A typical Phillips curve diagram secret plans rising prices on the perpendicular axis against unemployment on the horizontal, and possesses a negative gradient. A curve based on the rules outlined therefore far will demo a individual degree of unemployment for any given value of rising prices. We can see that the gradient of the Phillips curve represents the forfeit ratio ( the rate at which one variable is traded against the other ) of rising prices and unemployment. Where unemployment is high and rising prices depression, an addition in rising prices of 1 % leads to a important bead in unemployment. As rising prices rises and unemployment is lowered, the alteration in unemployment becomes far less important ( the curve is convex ) . This makes good intuitive sense, as it follows much the same logic as sing the forfeit curve between the purchase of two goods in consumer theory. It should be noted, though, that the Phillips curve is non ever convex, and that it is non theoretically required to be. We can see from the curve that when rising prices is high we would anticipate unemployment to be low, and so for the period of the Phillip’s curve flower, it was.

However, in the 1970s for many states came a period of what came to be known as stagflation. This was a period of high rising pricesandunemployment, wholly contrary to what the Phillips curve predicted. This is because the Phillips curve led us to anticipate that at a given degree of rising prices we would detect a peculiar degree of unemployment. During the 1970s rising prices would be at the same degree as it had been during the ‘60s, yet unemployment would be 3 points higher. This meant that some circumstance had arrived which caused the curve to no longer keep true. Since the Phillips curve evolved as an empirical regularity ( instead than theoretical relationship ) , this was double detrimental, and greatly hampered the credibleness of the curve. However, there was some theoretical justification for the Phillips curve, and by adding other factors to the relationship it is possible to explicate how stagflation occurred utilizing the Phillips curve model.

The theoretical footing for the Phillips curve comes from sing aggregative supply and demand in the short term. If a authorities uses pecuniary or financial policy to spread out aggregative demand ( through, for illustration, a revenue enhancement cut ) , this causes a displacement along the short-term sum supply curve, ensuing in higher monetary values and higher end product. As end product has increased, and end product is a map of capital and labor, unemployment falls, as more workers are needed to bring forth the end product. However, monetary values have besides increased every bit compared to the old period – this means higher rising prices. As such, it is non that there is a causal relationship between rising prices and unemployment ; it is merely that the actions taken to increase one variable will take down the other.

This justification brings with it several major deductions. Chiefly among these is that the addition in end product is impermanent. End product is ( in the long tally ) independent of monetary value degree – end product is a map of capital and labor. As such, the long-term sum supply curve is perpendicular. This means that the end product addition caused by the expansionary financial or pecuniary policies is impermanent – end product returns to its equilibrium degree, at a new, even higher monetary value degree. This is because the initial enlargement in demand causes a displacement along the short-term AS curve ( the short tally AS curve is non perpendicular – there are a assortment of accounts for this, gluey wages/prices and imperfect information being the chief grounds ) , taking to an addition in end product. However, as these ‘stickiness’ issues subside ( or workers come to gain their information was flawed, and comprehend that merely nominal variables have changed ) , supply displacements back to its long tally curve, switching the short tally demand and supply curves upward, returning to natural end product but higher monetary value degrees.

As such, the tradeoff between rising prices and unemployment illustrated by the Phillips curve is a short tally phenomenon, and we are returned to the classical duality – that nominal variables ( rising prices ) do non impact existent variables ( unemployment )in the long tally. So we are left with the Phillips curve as a short-run policy doing tool. However, even as a short-run device our current model does non explicate the stagflation period of the 1970s – or miscellaneous inflation/unemployment combinations since.

This is because rising prices is made up of three constituents. The rising prices we have been sing therefore far, and the one accounted for in the Phillips curve is known as demand-pull rising prices, so called because it is rising prices caused by displacements in the aggregative demand curve. The mathematical term for demand-pull rising prices is i?? ( u-uN) , where U is unemployment, uNis the natural rate of unemployment and i?? is a coefficient mensurating the sensitiveness of rising prices to unemployment. This look is derived from the aggregative demand scenario mentioned earlier and Okun’s jurisprudence ( a correlativity sing divergences in the natural rate of end product and the natural rate of unemployment ) – a displacement in the demand curve represents a displacement from the natural rate of end product, and Okun’s jurisprudence allows us to find the consequence this displacement in end product will hold on unemployment. However, rising prices is a complex phenomenon, and one of the grounds for its continuity is outlook of rising prices.

Solow summarised the thought that rising prices occurred each twelvemonth because it was expected to. Essentially, given that rising prices is a regular phenomenon, consumers all expected monetary values next twelvemonth to be higher by a given sum than this twelvemonth, and take this into history when doing their determinations – from labour supply to ingestion picks. The manner we factor this in to our equation varies depending how we consider consumers to organize their outlooks. The simplest agencies, known as adaptative outlooks, is to see that consumers will anticipate rising prices this period to be the same as rising prices last period – that is i?°vitamin E= i?°t-1. This creates rising prices inactiveness – every bit shortly as rising prices occurs, consumers begin to anticipate rising prices. Since their outlook of rising prices contributes to existent rising prices, rising prices so persists – it has inertia.

However, this theoretical account of outlooks has faced unfavorable judgment, as it is slightly simplistic, particularly when we typically assume consumers to be rational. An alternate theoretical account of outlooks is that of rational outlooks. This theoretical account assumes that consumers take all available information in to account when organizing their outlooks. This means that if the authorities announces it is traveling to take down rising prices, and this is considered believable by consumers ( credibleness is a major issue when sing outlooks on rising prices ) , it is possible to take down rising prices painlessly – without increasing unemployment. In the universe of rational outlooks the Phillips curve does non keep. Anyway, irrespective of how they are formed, outlooks of rising prices, i?°vitamin E, is a subscriber to rising prices.

The 3rd subscriber to rising prices is supply dazes. This represents exogenic displacements of supply – such as unexpected monetary value rises, for illustration of oil during the 1970s. This is sometimes known as cost-push rising prices. An inauspicious monetary value daze, such as the antecedently mentioned illustration, represents an addition in rising prices. A good supply daze, such as a sudden monetary value bead, or new production engineering, causes a bead in rising prices. Supply dazes are represented by the symbol i?® .

Uniting these three considerations allows us to organize a new equation for the Phillips curve that contains the extra factors continued. This is shown below:

i?°=i?°vitamin E+i??( u-uN) +i?®

This model allows us to see why the stagflation of the 1970s occurs. Additions in i?°vitamin Eor i?® represent displacements in the Phillips curve ( the 2nd equation is the Phillips swerve itself ) . In the 1970s, the OPEC group set quotas on their oil production, drastically take downing universe supply of oil, and taking to a crisp addition in oil monetary values. This represented an inauspicious supply daze, or an addition in i?® . This caused the Phillips curve to switch upwards, taking to a greater degree of unemployment at every degree of rising prices.

The upwards shifted curve is the same form as the old curve, but consequences in a systematically higher degree of unemployment at each degree of rising prices. Returning to the scenario raised earlier ( where unemployment was 3 points higher at each degree of rising prices ) , we can reason that the supply daze of the oil crisis caused a 3-point displacement in the Phillips curve.

As such, the augmented Phillips curve is capable of demoing why at different times there may be several different degrees of unemployment at a given degree of rising prices. However, this does non turn to all of the unfavorable judgments mentioned. The Phillips curve remains a short-run relationship – there is no justification for suggestion there is a long-running relationship between rising prices and unemployment, and so the Phillips curve is seen as a short tally tool.

This becomes debatable when sing the part of outlooks to rising prices. The cost of expected and unexpected rising prices to an economic system are controversial, and hard to mensurate, but it is certain that unforeseen rising prices can take to disequilibrium, and even expected rising prices incurs shoe-leather and bill of fare costs ( the cost of altering monetary values – publishing new catalogues, etc ) . These costs themselves can hold considerable knock-on economic effects. As such, a low and changeless degree of rising prices is seen as of import to a successful economic system.

This means that changing the degree of rising prices to accomplish short-run displacements in unemployment can be seen as a damaging action if it alters consumers’ outlooks of rising prices, as it amendss the government’s credibleness when it states that it will keep rising prices to a peculiar degree.

Expectations cause farther troubles for the Phillips curve. If we consider the rational outlooks theoretical account, consumers absolutely predict rising prices and so the relationship with unemployment does non keep. If we are advocators of the rational outlooks theory, we must be critics of the Phillips curve. It should be noted, though, that empirical grounds suggests that outlooks do non be given to act absolutely rationally, and that though the ‘cost’ of deflation can be lower than an adaptative outlooks theoretical account would foretell, it is still non complimentary.

The Phillips curve, in its original signifier, does non stand up to scrutiny, moving merely as an empirical regularity for a little figure of states over a peculiar clip period. However, one time refined to see other lending factors to rising prices it can function as a utile analysis and policy-making tool. Empirical grounds supports the curve, demoing that despite prevailing theoretical expostulations that there is a relationship between unemployment and rising prices. It should be remembered, though, that the Phillips curve represents merely a short-run state of affairs, and so should be used with cautiousness.

Bibliography

Burda, M. and C. Wyplosz ( 2005 )Macroeconomicss: A European Text, Fourth Edition. Oxford University Press.

Dornbusch, R. , S. Fischer and R. Startz ( 2004 )Macroeconomicss, Ninth Edition. McGraw Hill Publishers.

Mankiw, N.G. ( 2002 )Macroeconomicss, Fifth Edition. Deserving Publishers.