Unit 5.06_ The Phillips Curve

Unit Overview

• Unit 5.06: Focus on Macro Objectives, Weighted Price Indices & The Phillips Curve (HL)

Phillips Curve Insights

• Quote: "To the extent that a Phillips curve exists, it's a moveable feast." - Neal Soss

• Debate Around Phillips Curve:

  • Importance of the Phillips curve in monetary policy discussions, with emphasis on its relevance stated by Jay Powell.

  • Criticism of the curve, noting it failed during stagflation of the 1970s.

  • Conflict arises regarding its predictive power and its basis in faith-based economics.

Weighted Price Indices

Calculating Inflation

• Weighted Price Index Definition:

  • A tool to measure inflation using a basket of products that are assigned different weights based on spending habits.

• Price Index Types: Includes commodity and consumer price indices.

Example Calculation of Price Index

• Hypothetical Basket of Goods:

  • Categories include Housing, Foodstuffs, Travel, Clothing, and Entertainment.

  • Given Index values for two sequential years (Year X and Year X + 1).

• Average Index Calculation:

  • Average Index for Year X: 590 / 5 = 118

  • Average Index for Year (X + 1): 600 / 5 = 120

• Inflation Rate Calculation:

  • Formula used: ( \text{Inflation Rate} = \frac{Index_{(X + 1)} - Index_X}{Index_X} \times 100 )

  • For this example: ( \frac{120 - 118}{118} \times 100 = 1.69% )

Importance of Weights in Price Indices

• Why Weights Matter:

  • Equal weighting across categories is simplistic and inaccurate.

  • Example: Price changes in housing will impact consumers' finances more significantly than clothing.

  • Weights reflect relative spending habits and adjust the inflation calculation accordingly.

• Weighted Prices Example:

  • A table shows weighted index calculations leading to a more accurate depiction of consumer expenditure, showing Year X and (X + 1) with their calculated indices.

• Inflation Rate with Weights:

  • The weighted inflation rate yielded a more significant result (3.83%) compared to the simplistic index (1.69%).

The Phillips Curve Dynamics

Trade-Offs Between Inflation & Unemployment

• Original Concept:

  • 1958 study by Alban Williams Phillips noting an inverse relationship between wage changes and unemployment levels.

• Mechanism Explained:

  • If demand for labor increases, wages rise, and similarly, higher unemployment leads to lower wage offers.

• Economic Trade-Off:

  • A graphical representation often portrays that lower unemployment correlates with higher inflation rates.

  • Government policies can reduce unemployment but often at the expense of rising inflation rates.

Historical Context

• Post-1970s Shift:

  • During the 1970s, simultaneous high inflation and unemployment (stagflation) challenged Phillips curve validity, leading to widespread criticism.

Long-Run Phillips Curve Perspective

• Critique by Monetarists:

  • Milton Friedman and monetarists argued no true trade-off exists between inflation and unemployment in the long run.

• Equilibrium Points:

  • At equilibrium (point A), natural unemployment exists alongside stable inflation rates; expansionary policies may temporarily reduce unemployment but eventually lead to higher inflation.

• Recovery Mechanics:

  • Inflation expectations and resulting negotiations push the economy to a state of higher inflation with returning unemployment to its natural rate (new short-run Phillips curve).

Natural Rate of Unemployment (NRU)

• NRU Defined:

  • The level of unemployment consistent with stable inflation, where market forces balance out.

• Impact of Policies:

  • Continuous expansionary policies can lead to increasing inflation rates without reducing the natural rate of unemployment.

• Supply-Side Solutions:

  • Reduction of the NRU is more effectively achieved through supply-side, rather than demand-side, economic policies.

Conclusion

• Key Takeaway:

  • Understanding the Phillips Curve is vital in grasping the complex interplay between inflation and unemployment as it relates to macroeconomic policies.

Additional Resources

• Kognity Reading (Equity & Equality): Links provided for further reading.

• Assignments and Tasks: URLs for further assessments related to learning objectives.