2.8 The Phillips Curve

The Phillips curve

Relationship which suggests there is a trade off between unemployment and inflation

Natural rate of unemployment (NRU)

Rate of unemployment when the labour market is in equilibrium (labour demand is equal to labour supply)

Non-accelerating inflation rate of unemployment (NAIRU)

Rate of unemployment in an economy that is consistent with a constant rate of inflation

Possible Conflicts between Growth and Inflation

An overheating (fast-growing) economy may suffer accelerating inflation which then has negative effects on trade performance, business profits and jobs

Unemployment

A situation that occurs when a number of people in an economy are able and willing to work but are unable to gain employment 

Full employment

The level of employment as a result of everyone who is able and willing to work having a job, with the exception of those who are frictionally employed

Natural rate of unemployment 

The natural rate of unemployment is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level and where the aggregate supply of labour is in balance with the aggregate demand for labour.

At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and there is no involuntary unemployment

The Phillips Curve concept

States that inflation and unemployment have a stable and inverse relationship

According to the Phillips curve, the lower an economy's rate of unemployment, the more rapidly wages paid to labour increase in that economy. This can be because people expect the higher wages and unions have more bargaining power.

Policy trade-off is needed.

Curve

Curve shows a trade-off between inflation and unemployment. A demand-side policy to reduce unemployment could conflict with price stability

Shift in the Phillips Curve

An inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation

NAIRU on Phillips Curve

Where the long run Phillips Curve cuts the horizontal axis would be the rate of unemployment at which inflation was constant – the Non-Accelerating Inflation Rate of Unemployment (NAIRU)

Short-run vs long-run Phillips Curve 

Why is there a potential trade-off between unemployment and inflation?

An increase in aggregate demand (AD to AD2) 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 see an increase in inflationary pressures. With lower unemployment, workers can demand higher money wages, which causes wage inflation. Also, firms can put up prices due to rising demand.

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