THE STORY OF THE PHILLIPS

CURVE

A GROUP 3 INITIATIVE

In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation. While it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run.

IN SIMPLE WORDS

THE DEVELOPMEN

T-history in the

making

• William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published in the quarterly journal Economica.

In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined.

A. W. H. Phillips’s study of wage inflation and unemployment in the United Kingdom from 1861 to 1957 is a milestone in the development of macroeconomics. Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.

Phillips had mainly noted the relationship between the rate of change of money changes and the level of unemployment in an economy . It was later that other economists modified the curve and replaced the other variable with inflation.

The original phillips curve- Rate of Change of Wages against Unemployment, United Kingdom 1913–1948 from Phillips (1958)

Phillips conjectured that the lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must raise wages to attract scarce labor. At higher rates of unemployment, the pressure abated. Phillips’s “curve” represented the average relationship between unemployment and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time.

EXPLAINING THE RELATIONSHIP

One implication of this for government policy was that governments could not control unemployment and inflation with a Keynesian policy at the same time. They could have a reasonably low rate of inflation but this would lead to higher unemployment – there would be a trade-off between inflation and unemployment.

For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

KEYNESIAN NIGHTMARE

• At the height of the Phillips curve’s popularity as a guide to policy, Edmund Phelps and MILTON FRIEDMAN independently challenged its theoretical underpinnings.

• They argued that well-informed, rational employers and workers would pay attention only to real wages—the inflation-adjusted purchasing power of money wages. In their view, real wages would adjust to make the SUPPLY of labor equal to the DEMAND for labor, and the unemployment rate would then stand at a level uniquely associated with that real wage—the “natural rate” of unemployment.

CHALLENGING THE CURVE

• Both Friedman and Phelps argued that the government could not permanently trade higher inflation for lower unemployment. Imagine that unemployment is at the natural rate. The real wage is constant: workers who expect a given rate of price inflation insist that their wages increase at the same rate to prevent the erosion of their purchasing power. 

• Now, imagine that the government uses expansionary MONETARY or FISCAL POLICY in an attempt to lower unemployment below its natural rate. The resulting increase in demand encourages firms to raise their prices faster than workers had anticipated. With higher revenues, firms are willing to employ more workers at the old wage rates and even to raise those rates somewhat.

• For a short time, workers suffer from what economists call money illusion: they see that their money wages have risen and willingly supply more labor. Thus, the unemployment rate falls. They do not realize right away that their purchasing power has fallen because prices have risen more rapidly than they expected. But, over time, as workers come to anticipate higher rates of price inflation, they supply less labor and insist on increases in wages that keep up with inflation.

• The real wage is restored to its old level, and the unemployment rate returns to the natural rate. But the price inflation and wage inflation brought on by expansionary policies continue at the new, higher rates.

• This led to the distinction between the long run and the short run Phillips curve:-

NAIRUNon-Accelerating Inflation Rate of Unemployment

• New theories, such as  the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. The latter theory, also known as the "natural rate of unemployment", distinguished between the "short-term" Phillips curve and the "long-term" one. The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectations changed. In the long run, only a single rate of unemployment (the NAIRU or "natural" rate) was consistent with a stable inflation rate. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the Nobel Prize in Economics in 2006 for this.

• In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by the "Initial Short-Run Phillips Curve" in the graph. Policymakers can therefore reduce the unemployment rate temporarily, moving from point A to point B through expansionary policy. However, according to the NAIRU, exploiting this short-run tradeoff will raise inflation expectations, shifting the short-run curve rightward to the "New Short-Run Phillips Curve" and moving the point of equilibrium from B to C. Thus the reduction in unemployment below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run.

• Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve.

• However, in the 1990s in the U.S., it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actual unemployment rate fell below 4 % of the labor force, much lower than almost all estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.

Shifts in the Phillips Curve

a) Unfavorable supply shock

• If firms' costs rise, they are likely to pass these costs on to their customers in the form of higher prices (again, this is the mark-up pricing idea). Therefore, a "cost shock" will cause higher inflation, at least for a while.

– Higher costs will raise inflation for a given level of unemployment. Therefore, the Phillips Curve will shift upward.

Historical example

• The classic example of this situation is the oil price increases of the 1970s. In the early 70s, war in the Middle East led OPEC (Organization of Petroleum Exporting Countries) to impose an oil embargo on the U.S. Oil prices rose dramatically. Because energy is used in so many industries, the higher oil prices caused big cost increases throughout the economy.

• There was a similar problem when oil imports from Iran were reduced by the revolution that deposed the Shah of Iran (who was supported by the U.S.) in the late 1970s.

• Because the Phillips Curve shifts upward, inflation is higher after the cost shock (or "supply shock"). During the early 70s in the U.S., there were also forces raising unemployment. Thus, the Phillips Curve diagram looked like this .

Stagflation-SUPPORTING FRIEDMAN’S ARGUMENTS

• The 1970s provided striking confirmation of Friedman’s and Phelps’s fundamental point. Contrary to the original Phillips curve, when the average inflation rate rose from about 2.5 percent in the 1960s to about 7 percent in the 1970s, the unemployment rate not only did not fall, it actually rose from about 4 percent to above 6 percent.

OUR RESEARCH

Economics literature suggests that the Phillips curve is nonexistent in India. This study finds that supply shocks, namely droughts and oil crises, and the liberalization-policy shock of the early 1990s are the main reasons for the absence of the Phillips curve in India.

-still we tried to see whether there were any signs of phillips curve in the current economic scenario , we analysed the unemployment and inflation numbers for India for the past `10 years.

• In the short run too we cannot see the phillips curve relationship in India as suggested by the data above. There generally seems to be a direct relation between the inflation and unemployment in India.

THE PHILLIPS CURVE TODAY• Most economists no longer use the Phillips curve in its

original form because it was shown to be too simplistic. This can be seen in a cursory analysis of US inflation and unemployment data 1953-92. There is no single curve that will fit the data, but there are three rough aggregations—1955–71, 1974–84, and 1985-92—each of which shows a general, downwards slope, but at three very different levels with the shifts occurring abruptly. The data for 1953-54 and 1972-73 do not group easily, and a more formal analysis posits up to five groups/curves over the period.

• But still today, modified forms of the Phillips Curve that take inflationary expectations into account remain influential. The theory goes under several names, with some variation in its details, but all modern versions distinguish between short-run and long-run effects on unemployment. The "short-run Phillips curve" is also called the "expectations-augmented Phillips curve", since it shifts up when inflationary expectations rise, Edmund Phelps and Milton Friedman argued. In the long run, this implies that monetary policy cannot affect unemployment, which adjusts back to its "natural rate", also called the "NAIRU" or "long-run Phillips curve". However, this long-run "neutrality" of monetary policy does allow for short run fluctuations and the ability of the monetary authority to temporarily decrease unemployment by increasing permanent inflation, and vice versa.

References• WWW. Research PapersGoogle.com harvard.edu Tradingeconomics.com UC-BerkerlyCmie.com Stanford.eduWikipedia.org

Rbi.org.in JournalsUn.org Youtube.com Harvard economics review

Authors

Mankiw

CREDITS

Prithvi Ghag (35)Apurv Jain (10)

Sachin Shantaraju (37)

Prashakha Saxena(30)

Shreya Bakliwal(44)

Prateek Bharadwaj(31)