The Phillips Curve illustrates the relationship between inflation and unemployment. It was first proposed by A.W. Phillips in 1958, based on empirical data from the UK, showing an inverse relationship between wage inflation and unemployment. Later, this was extended to a broader relationship between price inflation and unemployment.
The traditional interpretation of the Phillips Curve suggested a trade-off: lower unemployment could be achieved at the cost of higher inflation, and vice versa. This idea was influential in the 1960s and guided policymakers who believed that monetary or fiscal stimulus could reduce unemployment, albeit with higher inflation.
However, this framework came under criticism in the 1970s when many economies experienced stagflation—high unemployment and high inflation simultaneously—challenging the trade-off assumption.
Distinguishing Between Short-Run and Long-Run Phillips Curve (2 marks)
Short-Run Phillips Curve (SRPC):
The short-run Phillips Curve reflects the original idea that inflation and unemployment are negatively related. In the short run, when prices and wages are sticky, an increase in aggregate demand can reduce unemployment and push up inflation. This implies that monetary or fiscal expansion can lower unemployment temporarily.
Graphically, the SRPC is downward sloping, indicating the inverse relationship. Policymakers, under this view, could choose a point along the curve depending on their preference between inflation and unemployment.
Long-Run Phillips Curve (LRPC):
Over time, economists like Milton Friedman and Edmund Phelps argued that the trade-off does not exist in the long run. They introduced the concept of a natural rate of unemployment (or Non-Accelerating Inflation Rate of Unemployment—NAIRU), where inflation expectations are fully adjusted, and unemployment returns to its natural level.
The long-run Phillips Curve is vertical at the natural rate of unemployment, implying that in the long run, changes in inflation have no effect on unemployment. Any attempt to keep unemployment below its natural rate would only cause accelerating inflation.
How Expectations Modify the Traditional Phillips Curve Framework (6 marks)
Expectations play a crucial role in modifying the Phillips Curve, especially through the development of adaptive expectations and rational expectations.
Adaptive Expectations:
Under adaptive expectations, people form their inflation expectations based on past inflation rates. This was used in the expectations-augmented Phillips Curve introduced by Friedman and Phelps.
In this model, when policymakers try to reduce unemployment below the natural rate by increasing demand, inflation rises. Initially, if people expect inflation to remain low, real wages fall, and unemployment drops. But over time, as people adjust their expectations upward based on observed inflation, they demand higher nominal wages. This erodes the earlier real wage reduction, causing unemployment to rise back to its natural level.
This creates a shifting SRPC: with each policy attempt to reduce unemployment below NAIRU, the curve shifts upward, resulting in higher inflation with no long-term gain in employment. This dynamic explains the experience of stagflation in the 1970s.
Rational Expectations:
The rational expectations theory, developed by economists like Robert Lucas and Thomas Sargent, assumes that individuals use all available information, not just past data, to forecast inflation.
According to this view:
- People anticipate policy moves and adjust their behavior immediately.
- As a result, expansionary policies are neutralized quickly because workers demand higher wages as soon as they expect higher inflation.
- Therefore, there is no trade-off even in the short run—the Phillips Curve is vertical both in the short run and the long run.
This perspective underlies the New Classical school of thought and supports the idea of policy ineffectiveness: systematic monetary policy cannot manage unemployment, only surprise inflation can have short-term real effects—but these surprises are unlikely if expectations are truly rational.
Conclusion
The traditional Phillips Curve suggested a stable, exploitable trade-off between inflation and unemployment in the short run. However, the introduction of adaptive expectations modified this view by showing that the trade-off is temporary. With rational expectations, even this short-run trade-off disappears. As a result, modern macroeconomics emphasizes that inflation expectations are key, and that sustained unemployment reduction must come through structural, not just monetary, measures.
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