What is the Phillips curve and does it hold true

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a) Explain what a Phillips curve is. b) How did it originate. c) Does it hold true?

What a Phillips curve is?

The basic Phillips Curve idea - economic trade-offs

In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of data of UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between unemployment and inflation. The theory behind this was fairly straightforward. Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise. If the Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.

The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets arising from an increase in national income, output and employment.

The labour market: As unemployment falls, some labour shortages may occur where skilled labour is in short supply. This puts extra pressure on wages to rise, and since wages are usually a high percentage of total costs, prices may rise as firms pass on these costs to their customers

Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does demand for these components and raw materials.

Product markets: Rising demand and output puts pressure on scarce resources and can lead to suppliers raising prices to widen profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap)

How did it originate.

Explaining the Phillips Curve concept using AD-AS and the output gap

Let us consider the explanation for the trade-off using AD-AS analysis and the concept of the output gap.  In the next diagram, we draw the LRAS curve as vertical - this makes the assumption that the productive capacity of an economy in the long run is independent of the price level. 

We see an outward shift of the AD curve (for example caused by a large rise in consumer spending) which takes the equilibrium level of national output to Y2 beyond potential GDP Yfc. This creates a positive output gap and it is this that is thought to cause a rise in inflationary pressure as described above. Excess demand in product markets and factor markets causes a rise in production costs and this leads to an inward shift in short run aggregate supply from SRAS1 to SRAS2. The fall in supply takes the economy back towards potential output but at a higher price level.

So this might help to explain the Phillips Curve idea. We could equally use a diagram that uses a non-linear SRAS curve to demonstrate the argument. The next diagram shows the original short-run Phillips Curve and the trade-off between unemployment and inflation:

Does it hold true?

The Phillips curve hold true as per theory if there are evidence that the trade-off Phillips curve is alive and well in particular places. Following are some research to support this argument.

The expectations-augmented Phillips Curve

The original Phillips Curve idea was subjected to fierce criticism from the Monetarist school among them the American economist Milton Friedman.  Friedman accepted that the short run Phillips Curve existed - but that in the long run, the Phillips Curve was vertical and that there was no trade-off between unemployment and inflation.

He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by a large monetary expansion and this had the effect of driving inflationary expectations higher, then this would cause an upward shift in the short run Phillips Curve.

The monetarist view is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on jobs. Friedman argued that a government could not permanently drive unemployment down below the nonaccelerating inflation rate of unemployment (NAIRU) - the result would be higher inflation which in turn would eventually bring about a return to higher unemployment but with inflation expectations increased along the way.

Friedman introduced the idea of adaptive expectations - if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods. And they (or the trades unions who represent them) may then incorporate these changing expectations into their pay bargaining. Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and ultimately higher prices for the goods and services we need and want to buy.

This is illustrated in the next diagram - inflation expectations are higher for SPRC2. The result may be that higher unemployment is required to keep inflation at a certain target level.

The expectations-augmented Phillips Curve argues that attempts by the government to reduce unemployment below the natural rate of unemployment by boosting aggregate demand will have little success in the long run. The effect is merely to create higher inflation and with it an increase in inflation expectations. The Monetarist school believes that inflation is best controlled through tight control of money and credit. Credible policies to keep on top of inflation can also have the beneficial effect of reducing inflation expectations - causing a downward shift in the Phillips Curve.

The long run Phillips Curve

The long run Phillips Curve is normally drawn as vertical - but the long run curve can shift inwards over time

An inward shift in the long run Phillips Curve might be brought about by supply-side improvements to the economy - and in particular a reduction in the natural rate of unemployment. For example labour market reforms might be successful in reducing frictional and structural unemployment - perhaps because of improved incentives to find work or gains in the human capital of the workforce that improves the occupational mobility of labour.