2.8 The Phillips Curve

define the phillips curve

the idea that a shortage of labour might set off an increase in wages

there is a trade off between reduction in unemployment and increases in inflation (demand pull AND cost push)

what happens when demand for labour is high?

firms will be prepared to bid up wages in order to attract labour
this is then passed on the form of higher prices

diagram of the phillips curve

diagram of inflation in the long run (aka keyensian?)

why does the trade off exist?

an increase in aggregate demand (AD to AD 1) causes higher real GDP (Y1 to Y2)
therefore, firms employ more workers and unemployment falls
however, as the economy gets closer to full capacity, we can see an increase in inflationary pressures
with lower unemployment, workers can demand higher wages which causes wage inflation

also, firms can put prices up due to rising demand

therefore, in this situation, we see falling unemployment, but higher inflation

do neoclassicals believe in the phillips curve trade off

no, they have always been critical of it

what do neoclassicals argue about the phillips curve trade off?

in the long run there is no trade off as LRAS is inelastic

explain the neoclassical view of the phillips curve

1) they say if there is an increase in demand, then workers demand higher nominal wages
2) when they receive higher nominal wages, they work longer hours because they feel wages have increased
3) this increase in AD (C up) causes inflation, and therefore, real wages stay the same
4) when workers realise rreal wages are the same as last year, they change their price expectations (aka money illusion, workers do not see this extra money in wages)
5) then they no longer supply extra labour
6) so real output returns to its original level and unemployment remains unchanged, but we have a higher inflation rate

would neo classicals argue unemployment is a supply side phenomenon?

yes

what does this mean in terms of policy methods to reduce unemployment?

they would say that demand side policies can only ever temporarily reduce unemployment by an ever increasing inflation rate
they that unemployment is determined by the natural rate of unemployment

define the NRU

natural rate of unemployment
rate of unemployment where there is only frictional and structural unemployment, as real wages will have adjusted to the equilibrium level

what is the non accelerating inflation rate of unemployment

rate of unemployment at which inflation will stabilise. At this rate of unemployment, prices will rise at the same rate each year.