Question

What is Phillip Curve? How to derive from AS - AD model? In what circumstances, PC will move right or left? What are the different views of Phillips Curve between classical economic and Keynesian economics? Why ?

Answer 1

Phillips Curve, developed by AW Phillips, states that there exists an inverse relationship between inflation and unemployment rates. The theory of Phillips curve explains, while experiencing economic growth, more jobs are created in an economy i.e. lower unemployment but at the cost of high inflation.

Using the below model of AD-AS, we can derive the short run Phillips Curve:

· Panel (a) in the below figure shows the typical AD-AS module, where X-axis shows the real GDP and Y-axis shows price level. Panel (b) shows the relationship between inflation and unemployment, where X-axis shows the unemployment rate and Y-axis shows the inflation rate.

· Initially, the economy is at short-run equilibrium at Point A, where Short-run Aggregate Supply Curve (SRAS) and aggregate demand curve AD1 intersect. Here, equilibrium level of output produced is Y1 at the equilibrium price level P1. Let’s say at this point the unemployment rate in the economy is 6% and the inflation rate is 1%. This combination is represented in Panel b.

· Suppose, in order to increase employment, the government implements fiscal and monetary policy tools that boost the aggregate demand in the economy. This shifts the AD curve rightwards from AD1 to AD2. The economy moves to a higher equilibrium at point B. Here aggregate output rises from Y1 to Y2 that increases employment (decreases unemployment) and increases the price level leading to inflation. The corresponding Point B, is reflected in panel (b), where unemployment rate fall to 4.5% and the inflation rate increases to 2%.

· Further we assume, in order to reach near the full employment level the government again implements some monetary and fiscal measure that further boosts the aggregate demand and shift the AD curve rightwards from AD2 to AD3. Here output increases to Y3 and price level increases further to P3. The equilibrium is achieved at Point C, where AD3 and SRAS intersect. The corresponding point C, is shown in Panel (b), where unemployment further falls to 3% and inflation rate rises to 3.5%.

· As we connect the points A, B, C and so on, we get a downward sloping curve that shows a negative tradeoff between inflation rate and unemployment rate, known as the short-run Phillips curve.

Factors That Causes Shift In the Phillips Curve

a) Rightward Shift

o Factor causing a decrease in short-run aggregate supply curve such as higher input prices, results into rightward shift of the Phillips curve. In other words, at any given level of unemployment rate, the inflation rates are higher.

o Increase in expected rate of inflation causes the Short-Run Phillips Curve to shift right, that further leads to an increase in actual rate of inflation.

b) Leftward Shift

o Factor causing an increase in short-run aggregate supply curve such as lower input prices, results into leftward shift of the Phillips curve. In other words, at any given level of unemployment rate, the inflation rates are lower.

o Fall in expected rate of inflation causes the Short-Run Phillips Curve to shift left, that further leads to a decrease in actual rate of inflation.

Classical Verses Kenyan View

o According to classical economists, the inverse relation between inflation and unemployment exists only in the short-run and it breaks down in the long run. They argue, if aggregate demand is increased, the workers demand higher wages. Increase in higher wages is accompanied by increase in price levels that keeps the real wages constant. Due to this, the workers change their price expectation and no longer supply extra labor to complement the increased aggregate demand. Thus, real aggregate out-put moves back to it’s potential level and unemployment remains unchanged with an increase in inflation rate. Hence, in the long-run the Phillips curve is perfectly inelastic just like the Long-run aggregate supply curve, where the unemployment rate is at its natural level. Any changes in the aggregate demand just causes a change in inflation rate and not unemployment in the long run.

o As per Keynesian Economists, there certainly exists demand deficient unemployment. In the long-run demand-side monetary and fiscal policies can reduce unemployment with some level of inflation. Such situations are more prevalent when there is a huge recessionary gap and increasing aggregate demand reduces unemployment with a moderate increase in inflation rate.