Question

Draw a short run Philips curve. Label it in full, Explain the reasons that underlie the short run cause and effect relationship, as originally stated by A. W. Philips.

Answer 1

A.W Philips published his observations in Great britain in 1958 in which he stated the inverse realtionship between inflation rates and unemployment . Philips curve is the diagramatic/graphical representation of the inverse correlation that exists between inflation and unemployment in short run.The philis curve is as follows:

Here the Philips curve is labled as SRPC 1. We can clearly see the downward slope of the same, which shows the inverse relationship between the Rates of inflation and rates of unemployment i.e when inflation rises , unemployment falls and vice versa.

In the graph , when theb rate of unemployment is 3% , the corresponding inflation rate is 6% , but when the unemployment rate increases to 5% ,the inflation rate falls to 2%. This indicates that there is an opposite movement between the two, though the relation is not a linier one.

The underlying reason for such behaviour is:

In this theory, workers are assumed to be completely rational and well informed. In such a scenario, when there is an increase in inflation rate (i.e prices of the goods and services rise ), their buying power reduces if there is no rise in there wages .

This means that even though their nominal wage remains same , the real wage/income falls.As a result of which they negotiate with the producers in order to increase their wages(nominal wages).

As nominal wages increase, the cost of production rises and so the profit falls. As this profits fall, producers will produce less and thus employ lesser people than before. This causes employment to fall. This is more of a long term phenomenon.

In short run, whenever the GDP increases,it is alway accompanied by some increase in inflation . This rise in GDP is because of increased production of goods and services. In order to produce more, the producers employ more laborforce , causing unemployment rate to fall. Therefore,we can say that,in short term, when inflation rate increase, unemployment rate falls