Question

I would like to know the relation between theta changing the Philips curve relation. I have concluded the following situations: 1. When theta equals zero, we get the original Phillips curve, a relation between the inflation rate and the unemployment rate; 2. When theta is positive, the inflation rate depends not only on the unemployment rate, but also on last year's inflation rate; 3. When theta equals to 1, we get a modified Philips curve, and the relation becomes that the unemployment rate affects not The Inflation Rate now, but rather the Change In Inflation Rate, high unemployment leads to decreasing inflation, and low unemployment leads to increasing inflation.

Now, my questions are: If there is an increase in theta, now the inflation rate would be based on last year's inflation rate and the change in inflation is increased since there is a rise in theta; what would it do to the unemployment rate then? Is it right to say now there would be a steady (instead of a direct) reduction in the unemployment rate, since now the change in inflation rate is increased? What about to the natural rate of unemployment then, I saw that the formula only has Ut but does not have Un (natural rate of unemployment), so does it mean that it cannot be determined? Thanks!

Answer 1

PHILLIPS CURVE

Professor Phillips urged there was a close link between the level of unemployment and the rate of wage increase. Phillips curve expresses an inverse relationship between the rate of unemployment and the rate of increase in money wages.

Prof. Phillips studied the relationship between unemployment and changes in money wages in the UK over the period 1862 - 1957. As a result of this study, he seems to have discovered a stable and inverse relationship over the whole period between the rate of wage increase and the percent of unemployment.

The Phillips Curve depicts the trade off between unemployment and money wages. It relates percentage change in money wages on the vertical axis with percentage of labour force unemployment on the horizontal axis. The curve is convex to the origin which shows the percentage change in money wages rises with decrease in the unemployment rate.

PHILLIPS CURVE

Suppose that ON rate of unemployment (3%) is associated with OM growth rate of money wages (2%). Suppose that the rate of labour productivity is 2% that is equal to OM. Since the growth rate of money wages equals the rate of labour productivity, the price level remains constant. If now the aggregate demand is increased, this lowers the unemployment rate to OT(2%) and raises the wage rate to OS(4% per year). If lower productivity continues to grow at 2% per annum, the price level will also rise at the rate of 2% per annum at OS in the figure.

Thus the money wage rate increase which in excess of labour productivity leads to inflation. To keep wage increase to the level of labour productivity(OM) inorder to avoid inflation, ON rate of unrmployment will have to be tolerated.

Samuelson and Solow extended the Philips analyses to the trade off between the level of unemployment and the rate of change in the level of prices. Thus , the Phillips curve suggests that unemployement can always be reduced by having more inflation and that the inflation rate can also be reduced by having more unemployment.

Criticism

Economists have criticised the Phillips curve.They argue that Phillips curve relates to the short run and it does not remains stable.It shifts with changes in expectations of inflation.In the long run,there is no trade off between inflation and unemployment.These views have been expounded by Friedman and Phelps in what has come to be known as "Accelerationist " hypothesis.A ccording to Friedman , the long run Phillips curve is vertical.

Tobins View

James tobin in his presidential address before the American Economic Association in 1971 proposed a compromise between the negatively sloping and vertical Phillips curve. Tobin believes that Phillips curve within limits but as the economy expands and employment grows the curve becomes even more fragile and vanishes until it become vertical at some critically low rate of unemployment. Thus Tobin's Phillips curve is kinked shaped, a part like a normal Phillips curve and the rest vertical, as shown in the below figure.

In the figure, UC is the critical rate of unemployment at which the Phillips curve becomes vertical where there is no tade off between unemployment and inflation. According to Tobin, the vertical portion of the curve is not due to increase in the demand for more wages but emerges from imprefections of the labour market. At the UC level, it is not possible to provide more employment because the job seekers have wrong skills or wrong age or sex or are in wrong place. Regarding the normal portion of the Phillips curve which is negatively sloping, wages are sticky downward because the labourers resist decline in their relative wages.

Like Tobin, Robert Solo doesnot believe that, the Phillips curve is vertical at all rate of inflation. According to him, the curve is vertical at positive rates of inflation and is horizontal at negative rates of inflation