Philips curve

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Philips curve

  1. 1. Philips CurveThe Philip curve examines the relationship between the rate of unemployment &the rate of money wage changes. Known after the British economist A.W.Philipswho first identified it, it expresses an inverse relationship between the rate ofunemployment & the rate of increase in money wages.Basing his analysis on data for the United Kingdom, Philips derived the empiricalrelationship that when rate of unemployment is high, the rate of increase inmoney wage rates is low.REASON: - This is so because workers are reluctant to offer their services at lessthan the prevailing rates when the demand for labour is low & unemployment ishigh so that wage rates falls very slowly.On the other hand, when unemployment is low, the rate of increase in moneywage rate is high.REASON:- This is because when the demand for labour is high & there are veryfew unemployed we should expect employers to bid wage rates up quite rapidly.The second factor which influences this inverse relationship between money wagerate & unemployment is the nature of business activity.In a period of rising business activity when unemployment falls withincreasing demand for labour, the employers will bid up wages.In a period of falling business activity when demand for labour is decreasing& unemployment is rising, employers will be reluctant to grant wageRATE OF INCREASE IN MONEYWAGE IS LOWUNEMPLOYMENT IS HIGHUNEMPLOYMENT IS LOW RATE OF INCREASE IN MONEYWAGE RATE IS HIGH
  2. 2. increases. Rather they will reduce wages. But workers & unions will bereluctant to accept wage cuts during g such periods. Consequently,employers are forced to dismiss workers, thereby leading to high rate ofunemployment.Thus, when the labour market is depressed, a small reduction in wages wouldlead to large increase in unemployment. Philips concluded on the basis of abovearguments that the relation between rate of unemployment & a change ofmoney wage would be high non-linear when shown on the diagram. Such acurve is called the Philips curve.U = UNEMPLOYMENTW = MONEY WAGE RATEP = PRICE LEVEL OR INFLATION RATE0 2 3 4 56-154321-23210MCBASPC5.5UP WFIGURE: - 1XY
  3. 3. Explanation:-The PC curve in Fig 1relate the %age change in money wage rate on thevertical axis with the rate of unemployment on horizontal axis. The PCCurve is known as Philip curve.The curve is convex to the origin which shows that %age change in moneywag rises with decrease in unemployment rate.In the figure, when the money wage rate is 2%, the unemployment rate is3%.But when the money wage rate is high at 4%; the unemployment rate islow at 2%.The original Philip curve was an observed statistical relation which wasexplained theoretically by Lipsey as resulting from the behavior of labourmarket in disequilibrium through excess demand.Several economists have extended the Philip curve analysis to the trade offbetween the rate of unemployment & the rate of change in level of prices orinflation rate by assuming that prices would change whenever wage rose morerapidly than labour productivity.If the rate of increase in money wage is higher then the growth rate oflabour productivity, price will rise & vice versa.But prices do not rise if labour productivity increases at the same rate asmoney wage rate rise.This trade-off between the inflation & unemployment rate can beexplained with fig 1 where inflation rate (P) is taken on vertical axisalong the rate of change in money wage (W).Suppose labour productivity rises by 2% per year & if money wage alsoincreases by 2% , the price level remain constant.Thus point B on the PC curve corresponding to percentage change inmoney wage (M) & unemployment rate of 3% equal 0% inflation rate (P)on the vertical axis.The difference between money wage rate & the rate of labourproductivity is inflation rate.
  4. 4. Now assume that economy is operating at point B.If now aggregatedemand is increased, this lower the unemployment rate of OT (2%) &raises the wage rate to OS (4%) per year.If labour productivity continues to grow at 2% per annum, the price levelwill also rise at the rate of 2% per annum at point C.With the movement of the economy from B to C, unemployment falls toT (2%).If point B & C are now connected they trace out a Philip curvePC.The shape of the PC curve further suggest that when the unemployment rate is lessthan 5.5% i.e. left to point A, the demand for labour is more than the supply & thistend to increase money wage rate. On the other hand, when the unemployment rateis more than 5.5 % i.e. right to point A, then supply of labour is more than thedemand which tends to lower wage rate. The implication is that the wage rate willbe stable at the unemployment.It is to noted that PC curve is the „conventional‟ or original downward slopingPhilip curve which show a stable & inverse relation between the rate ofunemployment & the rate of change in wages.
  5. 5. FRIEDMAN’S VIEW : THE LONG RUN PHILIP CURVEEconomist have criticized & in certain cases modified the Philip curve. They arguethat the Philip curve relate to short run & it does not remain stable. It shifts withchanges in expectations of inflation. In long-run there is no trade-off betweeninflation & unemployment. These views have been expounded by Friedman &Phelps in what has come to be known as the “accelerationist” or the “adaptiveexpectations” hypothesis.According to Friedman, there is no need to assume a stable downward slopingPhilip curve to explain the trade-off between inflation & unemployment. In fact,this relation is a short-run phenomenon. But there are certain variable which causethe Philip curve to shift over time & the most important of them is the expectedrate of inflation. So long as there is discrepancy between the expected rate & theactual rate of inflation, the downward sloping Philip curve will be found. But whenthis discrepancy is removed over the long run, the Philip curve becomes vertical.In order to explain this, Friedman introduces the concept of the natural rate ofunemployment. It represents the rate of unemployment at which the economynormally settles because of its structural imperfections. It is the unemployment ratebelow which the inflation rate increases & above which the inflation ratedecreases.At this rate, there is neither a tendency for the inflation rate to increase or decrease.Thus the natural rate of unemployment is defined as the rate of unemployment atwhich the actual rate of inflation equals the expected rate of inflation. It is thus anequilibrium rate of unemployment towards which the economy moves in the longrun.In the long run, the Philip curve is a vertical line at the natural rate ofunemployment. This is the natural or equilibrium unemployment rate is not fixedfor all times. Rather, it is determined by a number of structural characteristics ofthe labor & commodity market within the economy. These may be minimum wagelaws, inadequate employment information, deficiencies in manpower training,costs of labour mobility, & other market imperfections. But what causes the Philipcurve to shift over time is the expected rate of inflation. This refers to the extentthe labour correctly forecasts inflation & can adjust wages to the forecast.
  6. 6. Suppose the economy is experiencing a mild rate of inflation of 2% & anatural rate of unemployment (N) of 3%.At point A on the short-run Philip curve SPC1 in fig2 people expect this rateof inflation in the future.Now assume that the government adopts a monetary-fiscal programme toraise aggregate demand in order to lower unemployment from 3% to 2%.The increase in aggregate demand will raise the rate of inflation to 4%consistent with the unemployment rate 2%.SPC 1SPC 2SPC 3LPC0 1 2 346ECADBF82UNEMPLOYMENT (%)INFLATION%FIGURE: - 2XY
  7. 7. When the actual inflation rate (4%) is greater than the expected inflation rate(2%), the economy moves from point A to B along the SPC1 curve & theunemployment rate temporarily falls to 2%.This is achieved because the labour has been deceived. It expected theinflation rate of 2% & based their wage demand on this rate. But the workerseventually begin to realize that the actual rate of inflation is 4% which nowbecome their expected rate of inflation.Once this happens the short run Philip curve SPC1 shifts to the right toSPC2.Now workers demand increases in money wages to meet the higherexpected rate of inflation of 4%.They demand higher wages because, theyconsider the present money wages to be inadequate in real terms. In otherswords, they want to keep up with the higher prices & to eliminate fall in realwages.As a result, real labour costs will rise, firms will discharge workers &unemployment will raise form B (2%) to C (3%) with the shifting of theSPC1 curve to SPC2.At point C, the natural rate of unemployment is re-established at a higherrate of both the actual & expected inflation (4%).If the government is determined to maintain the level of unemployment at2%, it can do so only at the cost of high rates of inflation.From point C, unemployment once again can be reduced to 2% via increasein its aggregate demand along the SPC2 curve until we arrive at point D.With 2% unemployment & 6% inflation at point D, the expected rate ofinflation for workers is 4%. As soon as they adjust their expectations to thenew situation of 6% inflation, the short-run Philip curve shifts up again toSPC3, & the unemployment will rise back to its natural level of 3% at pointE.If point A, C, &E are connected, they trace out a vertical long run PhilipCurve LPC at the natural rate of unemployment. On this curve, there is notrade-off between unemployment & inflation.Rather, any one of several rates of inflation at point A, C &E is compatiblewith the natural unemployment rate of 3%.Any reduction in unemployment rate below its natural rate will be associatedwith an accelerating & ultimately explosive inflation. But this is only
  8. 8. possible temporarily so long as workers overestimate or underestimate theinflation rate.In long-run, the economy is bound to establish at the natural unemploymentrate.There is therefore no trade-off between unemployment & inflation except in theshort-run. This is because inflationary expectations are revised according to whathas happened to inflation in the post. So when the actual rate of inflation, say, risesto 4%, workers continue to expect 2% inflation for a while & only in the long runthey revise their expectation upward to 4%. Since they adapt themselves to theexpectations hypothesis. According to this hypothesis, the expected rate ofinflation always lags behind the actual rate. But if actual rate remains constant, theexpected rate would ultimately become equal to it.This leads to the conclusion that a short-run trade-off exists betweenunemployment & inflation, but there is no long trade-off between the two unless acontinuously rising inflation rate is tolerated.
  9. 9. CRITICISMThe accelerationist hypothesis of Friedman has been criticized on the followinggrounds:-1. The vertical long-run Philips Curve relates to steady rate of inflation. Butthis is not a correct view because the economy is always passing through aseries of disequilibrium position with little tendency to approach a steadystate. In such a situation, expectation may be disappointed year after year.2. Friedman does not give a new theory of how expectations are formed thatwould be free from theoretical & statistical bias. This makes his positionunclear.3. In one of his writing Friedman himself accepts the possibility that the long-run Philips curve might not just be vertical, but could be positively slopedwith increasing dose of inflation leading to increasing unemployment.4. Some economist have argued that wage rate have not increased at a high rateof unemployment.5. It is believed that workers have a money illusion. They are more concernedwith the increase in the money wage rates than real wage rates.6. Some economist regards the natural rate of employment as a mereabstraction because Friedman has not tried to define in concrete terms.

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