All about Philips Curve

1. INFLATION AND UNEMPLOYMENT
INFLATION
1. Historical experience of inflation
2. Causes of inflation
3. Costs of inflation: why is inflation a problem?
4. How can inflation be controlled?
UNEMPLOYMENT
1. Historical experience
2. Causes of unemployment
3. Policies to reduce unemployment

2. CAUSES OF INFLATION: THEORY
1. The quantity theory of money: inflation in the long-run
2. The excess demand model of inflation
3. Supply-side explanations of inflation: cost-push
4. A dynamic model of inflation: the wage price spiral

3. The quantity theory of money
Expenditure = Sales
quantity x velocity = price level x output
of money of circulation (P) (y)
(M) (V)
MV = Py
Suppose V and y are constant
then P = (V/y)M
or rate of change in P = rate of change in M

4. Excess demand model of inflation
If AD > AS……….prices rise
if AD < AS……….prices fall
AS
AD1
AD2
P2
P1
y1 y2
AD3
y3
Price
Output
But can output continue to rise?

5. AD can increase for several reasons:
• consumption suddenly increases
• investment increases (expectations improve)
• money supply increases (fall in r)
• exports increase (world trade expands)

6. Supply-side explanations of inflation
AD
AS1
AS4
AS3
AS2
Price
Output
P4
P3
P2
P1
y1 y2 y3 y4
Supply-side:
• increase in wages
• increase in import prices
• price-fixing by suppliers

7. Interaction between demand and supply
P1
P2
P3
y*
AD1
AD2
AD3
AS1
AS2
AS3
Govt policy is to keep y at y*:
- increase in costs offset by govt expansionary policy
But what about continued increase in prices?

8. Inflation is self-perpetuating:
• the wage-price spiral
- wages ‘cause’ prices
- prices ‘cause’ wages
• expectations of inflation
- wage negotiators look at future price levels
A dynamic model of inflation: the wage price spiral

9. The wage-price spiral: a dynamic model of inflation
Demand shock
Demand for
goods increases
Demand for
labour increases
Wages increase
Prices increase
Supply shock:
wage push
Supply shock:
e.g. OPEC
Real wage
bargaining
Cost-plus
pricing

10. A dynamic model of inflation: the augmented
Phillips curve
Price inflation
Wage inflation
Inflationary expectations: low
Inflationary expectations: high
p1
0
u1

11. Inflation
Unemployment
0
The Phillips Curve ‘Trade-off’
I
II
III
Inflation = Expected inflation - U

12. COSTS OF INFLATION
• menu costs
• shoe-leather costs: searching for best buy
• adverse effects on fixed income groups
• adverse effects on savings
•adverse effects on growth of GDP / capita
- lower investment due to uncertainty
- shortens investors time horizon (quick returns)

13. • costly to reduce inflation: dis-inflation => unemployment
• hyper-inflation is economically and politically disastrous
- complete collapse of market economy
- political instability

14. An example of hyper-inflation: Germany 1923
Price index
1921 July 1
1922 July 7
1923 Jan 195
July 5,230
August 66,017
Sept 1,674,755
Oct 496,209,790
Nov 15 54,448,000,000

15. COSTS OF DEFLATION
• borrowers find their real debts increasing
- discourages borrowing
- fall in asset prices reduces consumption
• lenders lose if debtors go bankrupt
• prices decline but wages are sticky
- decline in demand for labour
- fall in profits and investment
• real interest rates increase
- discourages investment
• leads to persistent recession: consumers delay spending

16. CONTROL OF INFLATION
• requires a powerful commitment to stable prices
- implies strict control over G (G = T)
• control over inflation in hands of CB
- inflation is lower in countries with independent CB
• govt needs to set clear inflation targets
- avoids govt pressure to relax monetary policy
• govt not permitted to finance deficits through creation
of high-powered money
- must borrow from private sector

17. •supply-side policies needed
- labour market flexibility
- anti-monopoly policy to increase competition
• high level of scrutiny of CB needed
- openness of how decisions are reached
- subject to scrutiny / questioning by elected body
• increasing emphasis placed on controlling interest rates
- less emphasis on controlling money supply
- use open market operations to control interest rates

18. •accurate forecasts of macro-economy needed
- lagged effect of monetary policy on economy
- need forecasts of turning points
- need to forecast ‘leading indicators’
(change in stock, long-term bond yields, commodity
prices, overtime working)

19. • stopping hyper-inflation
- nominal exchange rate ‘anchor’(e.g. dollarisation)
(to restrain cost-push inflation, including imported
inflation)
- restrictive fiscal policies (balanced budget)
- tight monetary policies (e.g. via independent CB)
- structural reforms
(liberalise financial markets, flexible labour markets,
free trade, privatisation of public enterprise,
anti-monopoly policies)

20. Argentina 1989-94
Fiscal balance Inflation Growth
(% GDP)
1988 -5.6 340 -1.9
1989 -0.6 3000 -6.2
1990 +1.4 2300 0.1
1991 +1.7 170 8.0
1992 +2.2 24 8.7
1993 +2.2 10 6.0
1994 +1.1 3 4.5
Short-term pain = long-term gain?

21. Has inflation been beaten?
• strong public support for price stability
- ageing population prefers low inflation
• financial markets strongly averse to inflation
- govt keeps close eye on financial markets
- pre-emptive action taken v. inflation
• greater price competition
- supply-side changes (labour markets, privatisation,
internet trading, creation of new markets)
- erosion of trade union power
• less vulnerable to oil price hikes
- more alternative sources of energy
- diversification in use of energy

22. UNEMPLOYMENT
• varies between countries
• varies within countries over time
• varies within countries at any point in time

23. CAUSES OF UNEMPLOYMENT
• collapse in aggregate demand
Policy action:
- need for fiscal / monetary policy action
• mismatch between labour demand and labour supply
- geographical immobility of labour
- skill / occupational mismatch
Policy action:
- need for spatial policies
- re-training programmes

24. • welfare benefits ‘too high’
Policy action:
- creation of work incentives (New Deal)
• hiring / firing costs too high
- employment legislation ‘too tough on employers’
Policy action:
- reduce fixed costs of employing labour

25. • wages too high (trade union power)
- wages are sticky downwards
- efficiency wage v. nominal wage
Policy action:
- more flexible wages needed
(especially with fixed exchange rate e.g. euro)

26. NATURAL RATE OF UNEMPLOYMENT
Definition: unemployment existing when the
economy is in equilibrium (AD =AS)
Determinants:
• job search
• structural factors (mismatch)
• voluntary unemployment
• unemployment benefit
• hysteresis and long-term unemployment

27. CHARACTERISTICS OF HIGH UNEMPLOYMENT
COUNTRIES
1. Unemployment benefit
• available for long periods
• no pressure on unemployed to get a job
2. Unions
• high degree of unionisation
• unions very active in wage negotiations
• no co-ordination in collective bargaining
3. Taxation
• high payroll taxes
• high minimum wages
• high income taxes