Question

(a) What is the major policy implication of the original Phillips Curve? How did it affect macroeconomic policies at that time? What major contribution it had made before the early 1970s? What kind of problem had emerged from the 1970s?

(b) Use Friedman’s Expectation Augmented Phillips Curve to explain how the above problem emerged? What is the major policy implication of Friedman’s Expectation Augmented Phillips Curve?

Answer 1

a) The major policy implication of Phillips Curve are-

1.The Phillips Curve suggests that monetary and fiscal used to control inflation without high level of umnemployment.

2.When the monetary policy is adopted employment above the natural rate can be reached at the cost of accelerating inflation.

3.Unemployment should not be a fitting aim for monetary expansion.

4.Models of inflation provides the so-called “missing equation” that explains how changes in nominal income divide themselves into price and quantity components.

5.On the policy front, it specifies conditions contributing to the effectiveness (or lack thereof) of expansionary and disinflationary policies.

6. It predicts that disinflationary policy will either work slowly (and painfully) or swiftly (and painlessly) depending upon the speed of adjustment of price expectations.

* Statistical testing of te hypothesis conducted in the early- to mid-1970s, led to criticisms of the adaptive-expectations or error-learning model of inflationary expectations and thus helped prepare the way for the introduction of the alternative rational expectations idea into Phillips curve analysis.

The tests themselves were mainly concerned with estimating the numerical value of the coefficient on the price-expectations variable in the expectationsaugmented Phillips curve equation.

If the coefficient is one, then the natural rate hypothesis is valid and no long-run inflation-unemployment trade-off exists for the policymakers to exploit. But if the coefficient is less than one, the natural rate hypothesis is refuted and a long-run trade-off exists.

b) Explaining the natural rate of unemployment Friedman said that the only scope of public policy in influencing the level of unemployment lies in the short run.

Friendman suggested out the possibility of influencing the long run rate of unemployment due to the vertical Phillips curve.The trade-off between unemployment and inflation donot exist according to Friedman. But the rapid inflation might be, unemployment always tends to fall back to its natural rate.

All this can be lowered by removing obstacles in labour market by frictions reduction. As a result public should improve the institutional structure to make the labour market responsible to changing patterns of demand.

Also some level of unemployment must be accepted as natural beacause of the existence of large number of part-time workers, unemployment compensation and other institutional factors.

The government should not use monetary policy to remove institutional restraints, restrictive practises, barriers to mobility etc. to both the workers and the employers.