Trade-off
between inflation and unemployment:
Keynes defined
inflation with respect to full employment level in an economy. According to
Keynes inflation is caused only after the full employment is reached in the
economy. We know that full employment level is that level where there is no
unemployment except natural rate of unemployment (NRU). What constitutes the
minimum NRU depends on the conditions of a particular country. This minimum
level of unemployment will remain in the country and it cannot be fully
removed. Thus in Keynesian analysis there is no trade-off between inflation and
unemployment.
Phillips Curve-
In 1958 A.W.
Phillips of London School of Economics published a research paper entitled “The Relation between Unemployment and the
rate of change of Money wages-1861 to 1957”.
He said that, “there appeared to be a connection between
the level of unemployment and the subsequent percentage increase in money
wages. Furthermore the relationship appeared to be stable”.
Other
researchers confirmed the Phillips’s findings. Furthermore, an equally stable
relationship was found to have existed for many years between the rate of
change in of prices (inflation) and the level of unemployment. It is this
relationship which is usually generalized in Phillips curve after the name of
A. W. Phillips.
Definition:
The
Phillips curve can be defined as a “curve showing the relationship between the
rate of inflation and level of unemployment”. The Phillips
curve shows that inflation
and unemployment have a stable and inverse relationship. The theory states that
with economic growth comes inflation, which in turn should lead to more jobs
and less unemployment.
The Phillips Curve shows the inverse relationship between unemployment
and inflation. PC is a downward sloping, curve, with inflation on the Y-axis
and unemployment on the X-axis. The theory says Increase in inflation decreases
unemployment, and vice versa. Thus any effort to decrease in unemployment will
in turn increase inflation.
Diagrammatic
Presentation:
This curve was derived
by plotting data of the level of unemployment in percentages against percentage
change in money wages covering the period 1861 to 1957. The percentage change
in money wages has also been interpreted as the rate of inflation. Inflation is
placed on vertical axis and the percentage of unemployment on horizontal axis.
On the basis of the shape of the curve and analysis of data Professor Phillips
analysed the changes in the wages of the workers in the United Kingdom from
1861 to 1913. He found as expected, that wages rose quickly when unemployment
was low, but advanced at a slower pace when unemployment was higher. The
relationship which became known as Phillips curve was also found to hold good
for 1913-1957.
The Phillips
Curve shows that as the level of unemployment falls, rate of inflation rises.
Since the basic relationship was observed stable for almost a century it was
assumed that it would continue to be stable. Therefore, the Phillips Curve was
interpreted as offering a policy menu to the policy makers where they could
choose lower unemployment if they were ready to accept higher inflation and
lower inflation if they were prepared to accept higher unemployment.
In fact, there
was tremendous interest in the Phillips Curve analysis as it was considered to
be stable and as a trade-off between inflation and unemployment.
Phillips work
motivated economists to examine the relationship between inflation and
unemployment in other countries. American economists Paul Samuelson and Robert
Solow fitted a Phillips curve on American experience from 1935 to 1959. Instead
of looking at wage inflation they took price inflation and unemployment.
Samuelson and Solow discovered that Phillips curve told the same story: to
reduce the rate of unemployment we will have to accept higher inflation&
vice versa. Thus Phillips curve accepting some sort of trade-off between
inflation and unemployment was widely accepted by the economists and policy
planners. It was also acceptable to Keynesian economists who advocate demand management
policies.
Criticism:
Both monetarist
and non-monetarists criticized the Phillips type inflation unemployment model
for different reasons.
First, we take
up the argument put forward by non-monetarists such as institutionalists,
structuralists or adherents of the sociological approach. These non-monetarists
drew our attention to the institutions operating in the labour market, such as
trade unions, and employers’ associations. The institutions of collective
bargaining and its impact on pay determination. For these reasons non-monetarists
believed that if there were an inflation unemployment trade-off either it had
altered, or that there may once have been such a trade-off but, there was no
longer. Some do believe that there never was such trade-off.
Monetarists
reject a stable Phillips Curve or its translation in to an inflation-
unemployment trade-off. While rejecting a stable Phillips Curve Monetarists nevertheless
believe that there might well be some short-run trade-off between the two. The
Phillips curve therefore has some relevance. By mid-1960s Phillips Curve had
been estimated in a number of countries for varying time periods with apparent
success. But in late 1960s and early 1980s many countries began to experience
combinations of inflation and unemployment the new phenomenon named stagflation*.
The Phillips Curve failed to provide a satisfactory answer and experienced an
empirical breakdown. Phillips Curve analysis was strongly criticized by
Friedman (1968) and Phelps (1967). These economists presented new explanations
of the relationship between inflation and unemployment based on expectations.
_________
*Stagflation is the combination of high unemployment rates along with
high inflation over a period of time. The new theory of Phillips Curve
predicts that there will be a trade-off between inflation and unemployment only
if the anticipated rate of inflation does not change. It predicts that Phillips
curve will shift up as the anticipates rate of inflation increases
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