Question

How is the short run Philips curve being used today (2020) in the USA? Give one example of the method being practiced today. What is the expected gain?  

Some countries have had Philips curve results completely contrary to the results expected in part A. Chile under President Salvatore Allende (1971-1973) and Venezuela from President Hugo Chavez (and continuing today with his successor) are examples of Philips curve based policies that have failed. Milton Friedman, and others, have warned that a long run Philips curve is harmful to a country’s economy.   Draw a new, separate Philips curve, following Milton Friedman’s warning.  Explain the cause and effect relationship that Milton Friedman specified would lead to this counterproductive outcome, as well.

Answer 1

Phillips Curve shows inverse relationship between rate of inflation and rate of unemployment in an economy. It was given by A.W. Phillips in 1958.

Policy makers in the United States have been dependent on the principle of Phillips Curve since 1960s. But during the slowdown in the economy in 1970s, market faced stagflation (inflation accompanied by stagnant growth, unemployment) for several quarters. Both unemployment and inflation increased shattering the notion of inverse relationship between inflation and unemployment. The trade-off between these two variables kept weakening the relationship in the long run.

Now the Federal Reserve in the US is using Phillips Curve in the short run only as Phillips Curve produces contradictory results in the long run. Today, US government aims to achieve a set rate of inflation through its Federal Policies (interest rate, Federal Fund Rate). Though due to higher unemployment rate and inflation rise, Federal Reserve has focused on labour market rather than controlling inflation.

Many countries based on Phillips Curve principle failed in economic policies due to its contradicting results in the long run or even in short run as well.

Milton Friedman said that if inflation rises in the long run and government increases interest rate to control it, then the economy will go towards recession and economic activity will be at halt. It will result in job loss. Similarly, low inflation rate will attract low interest rate which further lead to prices skyrocketing.

Phillips Curve in the short run:

Phillips Curve shows inverse relationship between rate of inflation and rate of unemployment in an economy. It was given by A.W. Phillips in 1958.

Policy makers in the United States have been dependent on the principle of Phillips Curve since 1960s. But during the slowdown in the economy in 1970s, market faced stagflation (inflation accompanied by stagnant growth, unemployment) for several quarters. Both unemployment and inflation increased shattering the notion of inverse relationship between inflation and unemployment. The trade-off between these two variables kept weakening the relationship in the long run.

Now the Federal Reserve in the US is using Phillips Curve in the short run only as Phillips Curve produces contradictory results in the long run. Today, US government aims to achieve a set rate of inflation through its Federal Policies (interest rate, Federal Fund Rate). Though due to higher unemployment rate and inflation rise, Federal Reserve has focused on labour market rather than controlling inflation.

Many countries based on Phillips Curve principle failed in economic policies due to its contradicting results in the long run or even in short run as well.

Milton Friedman said that if inflation rises in the long run and government increases interest rate to control it, then the economy will go towards recession and economic activity will be at halt. It will result in job loss. Similarly, low inflation rate will attract low interest rate which further lead to prices skyrocketing.

Phillips Curve in the short run:

Milton Friedman arguaemnst in favour of short run Phillips Curve:

1. Government can only manipulate inflation and unemployment relationship in the short run.
2. In the long run, inverse relationship between inflation and unemployment does not held valid.
3. Firms getting higher prices (higher profit) will not hire new labor to increase production. They are already getting higher profit against low cost of production. Hence the market will face higher inflation rate with no change in employment.
4. Contrary in the short run, if the price rises , firms will get more profits from the market. They will transfer this profit to employees in the form of higher wages or if the wages rise, firms will increase prices in the market to balance the increase in the wage payment.