The Philips Curve

1. The Philips Curve

2. Aims and Objectives Aim: • Understand Philips curve and the augmented Philips curve Objectives: • Define Philips Curve Trade Off • Explain demand and supply side policies which could be used to reduce unemployment • Analyse the usefulness of the Philips Curve • Evaluate the augmented Philips curve

3. Starter ‘The appropriate response to combat cyclical unemployment may be to stimulate AD. The supply side nature of unemployment needs to be tackled with supply side policies.’ What demand side & supply side policies can you think of to combat unemployment?

4. Demand Side & Supply Side Policies

5. The Philips Curve • AW Philips plotted data 1861-1957 • Short run trade off between unemployment and inflation • Falling unemployment might cause inflation to rise • Reducing inflation might only be at the expense of increasing unemployment • Inverse relationship

6. The Philips Curve • Level of inflation could be traded off against a level of unemployment. • Will happen as to reduce unemployment AD must be stimulated which will lead to inflation when there is excess demand/ Inflation % SRPC Unemployment %

7. The Philips Curve • 1970s high inflation and unemployment co-existed – stagflation. • On graph paper plot the following data for unemployment and inflation from 1970-1985. • Does there appear to be any obvious relationship, or had the Philips curve trade off truly broken down?

8. The Philips Curve

9. The Philips Curve • Does there appear to be any obvious relationship, or had the Philips curve trade off truly broken down?

10. Produce yourself a set of teaching notes and the Philips Curve. • You are then to have an economist speed dating session. • You will have 3 minutes to tell your hot date all about Philips Curve in an attempt to ‘woo’ them with economics knowledge. • Your date will then score you out of ten.

11. The Expectations Augmented Philips Curve

12. Aims and Objectives Aim: • Understand Philips curve and the augmented Philips curve Objectives: • Define Philips Curve Trade Off • Explain demand and supply side policies which could be used to reduce unemployment • Analyse the usefulness of the Philips Curve • Evaluate the augmented Philips curve

13. The Expectations Augmented Philips Curve • Monetarist economists were still adamant that the curve existed. • Milton Friedman accepted that there is a short run Philips Curve but that in the long run it was vertical. • He suggested that it’s impossible to reduce unemployment in the long run by, for example, increasing the money supply as this will just cause inflation.

14. The Expectations Augmented Philips Curve • You are walking down a street on your own, you know is a ‘bit dodgy’ to get home after a night out. • In this street you are mugged and your phone and wallet/purse is stolen and you are left with a black eye. • The next week you go out again and have the choice of walking down the same street having been ,mugged or going down an alternative street. What do you do?

15. The Expectations Augmented Philips Curve • Adaptive expectations: where decisions about the future are based upon past information. • If consumers experience high inflation in one month, they will learn from this and demand higher wages in the next period. • The result may be that higher unemployment is required to keep inflation at a target level. • Credible monetary policy may also have the effect of reducing inflation expectations, causing a leftward shift of the SRPC.

16. The Expectations Augmented Philips Curve LRPC Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

17. The Expectations Augmented Philips Curve LRPC • Economy initially at point A, unemployment at natural rate UN • At point A the rate of inflation is 0 Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

18. The Expectations Augmented Philips Curve LRPC • We assume that people form expectations of future inflation on the basis of the current rate of inflation. • Since current inflation is zero, workers expect future inflation to also be zero. Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

19. The Expectations Augmented Philips Curve LRPC • Gov. stimulates AD – movement along the SRPC1 to Pt B. • Unemployment – U1 and inflation rising to 5%. • Pt B is unsustainable. Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

20. The Expectations Augmented Philips Curve LRPC • For workers to supply more labour the RWR must rise. • In short run more workers may supply themselves, suffering from money illusion. • Believing that a 5% increase in wages is also a real increase. Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

21. The Expectations Augmented Philips Curve LRPC • For workers to supply more labour the RWR must rise. • In short run more workers may supply themselves, suffering from money illusion. • Believing that a 5% increase in wages is also a real increase. Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

22. The Expectations Augmented Philips Curve LRPC • Firms may also suffer from money illusion believing that rising prices mean sales revenues are rising faster than labour costs. • Workers and firms eventually see through money illusion and refuse to supply and demand labour. Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

23. The Expectations Augmented Philips Curve LRPC • Economy now moves to point C but with inflation expectations of 5% now built in. • Any attempt to boost AD, will result in a movement along SRPC2 and a return the NRU. Inflation % C 5% B A Unemployment % U1 UN SRPC2 SRPC1

24. The Expectations Augmented Philips Curve • The EAPC suggests that there is no long-run trade off between inflation and unemployment as the LRPC suggests. • Any attempt to reduce unemployment below NRU by stimulating AD is pointless and governments must tackle supply side causes if they wish to reduce unemployment. • NRU = voluntary frictional unemployment • NAIRU= non accelerating inflation rate of unemploymentthe level of U where I does not increase.

25. The Long Run Philips Curve • Can shift inward over time. • Due to supply side improvements in the economy • Labour market reforms may lead to a reduction in the NRU & NAIRU by improving occupational mobility of labour

26. Produce yourself a set of teaching notes and the EAPC. • You are then to have an economist speed dating session. • You will have 3 minutes to tell your hot date all about EAPC in an attempt to ‘woo’ them with economics knowledge. • Your date will then score you out of ten.