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In: Economics

My question has to do with the Phillips curve with Samuelson and Solow. They measured price...

My question has to do with the Phillips curve with Samuelson and Solow. They measured price inflation against the unemployment rate. The thing that I am confused about is why is stagflation extremely unlikely? I understand fewer people are buying things but wouldn't that make the price of some things then go up?

Solutions

Expert Solution

Prices of goods and services can increase from two channels: demand side and supply side. When demand is high people are willing to pay more and this increases the price level of most goods and services. Similarly when the supply is low due to increased cost of production, price of most goods and services increases.

It is the second case that is more noticeable during stagflation. Most of the times there is a recession or a stagnant economy that is not growing and yet there are increasing price level for most goods and services. People are not buying enough goods and services and still the price level remains high. This can happen only when aggregate supply shifts more to the left then the aggregate demand shifting to the left or not shifting at all.

As you mention, fewer people are buying goods and services than before, which should decrease the price level because the demand is low. But then the cost of production is way higher which decreases the aggregate supply more than the decrease in agreement demand. This causes stagflation, high inflation and high unemployment with lower GDP.


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