Question

Across the developed world, labor markets are at, or close to, levels of joblessness so low that they qualify as full employment. Yet in figures released in every country, there is little indication of the upward price pressures that many economists believe should follow tight labor markets. The Department of Commerce here in the U.S. reported that the Fed's key price gauge, the personal consumption expenditures price index, was up 2.0% percent in the past 12 months. This latest news was a shock to Fed officials who, like a majority of their counterparts abroad, still firmly believe in the established forecasting models that incorporate some version of the Phillips Curve.

Question: What problems with the Phillips Curve have surfaced before? To the extent that business is now more globalized than when William Phillips described the curve in 1958, could that be a reason why the Phillips Curve is failing? Or is the problem, you think, that unemployment rates have yet to fall far enough to trigger inflation? Perhaps Lucas is correct after all in thinking that if monetary policy is credible, there wouldn’t be a Phillips Curve at all? Discuss.

Answer 1

Answer :-

In 1958, A. W. Phillips (1914-1975) published an important paper that found a significant negative relationship between the rate of increase of nominal wages and the percentage of the labour force unemployed during important periods in British economic history. This relationship, which came to be called the Phillips Curve, suggested that government could reduce the unemployment rate by creating a more rapid rate of inflation of wages and prices. The basis for and validity of this apparent trade-off between inflation and unemployment is the focus of this Topic.

Although Phillips' original paper related the rate of growth of nominal wage rates to the unemployment rate, it has become customary to express the Phillips curve a relationship between the inflation rate and the unemployment rate, as shown by the curve PC .The inflation rate is on the vertical axis and the unemployment rate on the horizontal axis.The rationale for a negative relationship between the rate of inflation and the unemployment rate in the short-run is easily seen from the analysis in the preceding Topics in this Lesson. An unexpected expansion of the nominal money supply or decline in the demand for money will increase the long-run equilibrium price level. Workers and firms, unaware that the aggregate demand for output has increased, will increase wages and prices by less than will be required for equilibrium to be achieved. As a result, output and employment will increase above their full-employment or natural levels. As long as some price level response to the increase in aggregate demand occurs, the rate of inflation will increase as the unemployment rate declines.

It is straight-forward to argue that by increasing the rate of money growth and the equilibrium inflation rate, the authorities can induce a reduction in the unemployment rate as workers and firms adjust wages and prices with a lag and the excess demand spills over onto aggregate output. In the 1960s and early 1970s many economists believed that society faced a tradeoff between inflation and unemployment---by tolerating (creating) a higher inflation rate the authorities could engineer a reduction in the unemployment rate. Since unemployment is worse than inflation, an increase in the inflation rate seemed to be a useful cost to bear in promoting a good cause.

It should be obvious from what you have learned in the first three Topics of this Lesson that obtaining a long-run reduction the unemployment by generating a higher inflation rate is an illusion. Once workers and firms realize that the equilibrium rate of inflation has increased they will increase wages and prices by that equilibrium amount and full-employment will be continuously reestablished. The reduction in the unemployment rate occurs because wage and price setters are misinformed about the state of aggregate demand and fail to increase wages and prices fast enough. Once they learn what is happening workers and firms will adjust wages and prices to fully compensate for the inflation they know is occurring. At that point, unemployment will return to and remain at its natural rate.

To reduce the unemployment rate beyond the short-run, the authorities have to create a further increase in the inflation rate whenever wage and price setters come to anticipate the last increase, and then further again escalate the inflation rate when that increase has become fully anticipated, and so forth. But this too will fail because wage and price setters will come to realize that the government is increasing the equilibrium rate of inflation rate at an accelerating rate and will respond with an equivalent acceleration in the rate at which they increase wages and prices. The level of the Phillips curve thus depends on the expected rate of inflation. Government policy makers do not face a tradeoff between inflation and unemployment in the long run. And, though they face a short-run tradeoff, any attempt to exploit it will ultimately result in a permanent increase in the inflation rate. Moreover, once that permanent increase in the inflation rate has occurred, the government will only be able to eliminate it at the cost of an increase in unemployment above the natural rate.

Because of the problem of credibility, it turns out to be very difficult for governments to reduce their countries' inflation rates without causing temporary increases in unemployment rates. As a result, the short-run tradeoff of inflation for unemployment cannot be usefully exploited if inflation is to be controlled in the long run.