Question

After explaining what the Phillips curve (early development) is, explain what effect a decrease in the unemployment rate will have on the inflation rate. Justify your answer by discussing the underlying mechanisms.

Answer 1

The Phillips curve, originally, was a relationship between the rate of money wage changes and unemployment . It expresses an inverse relationship between the increase in money wage and rate of unemployment. That is when unemployment is high the rate of increase in money wage is low. This is because at a less than prevailing wage rate workers will not offer their services when the demand for labour is low and there is high unemployment so that wage rate falls very slowly. On the other hand, when unemployment is low, higher will be the rate of increase in money wage. This is attributed to the factor that there are a very few unemployed when the demand for labour is high and the employer is expected to bid wage rate up faster.

The nature of business activity is also another factor which influences the inverse relationship between money wage rate and unemployment . Unemployment falls in a period of increasing business activity as a result of increasing demand for labour. Thus the employer will bid up wages. Conversely, the employer will be reluctant to grant wage increases in a period of falling business activity when the demand for labour is decreasing and unemployment is rising.

The notion of Phillips curve can be extended to the trade off between the rate of unemployment and the rate of changes in the price level. This is done by assuming that the prices would change whenever the wages rose more rapidly than labour productivity. The prices will rise if the the rate of increase in money wage is higher than the growth rate of labour productivity and vice versa. This leads to inflation . But prices do not rise if labour productivity increases at the same rate as money wage rise .

When the unemployment decrease the aggregate demand is increased which raises the wage rate. Now, if labour productivity is not increased the price level will rise in accordance with the increase in money wage. Thus a decrease in unemployment rate leads to inflation