Monetary economics, critique of Phillip's curve

1. NAIRU
Prof. Prabha Panth, O.U. Hyderabad

2. 2
Criticism of Phillip’s curve analysis
1. Stagflation: during the 1970’s economies
experienced both inflation and stagnation.
2. Upward shift in Phillip’s curve: due to
increase in oil prices in the 70’s and upward
shift in the AS curve. Not stable
3. No Policy Relevance: Government cannot
target either unemployment or inflation.
4. No negative relationship: If the Phillip’s curve
shifts upwards, then the inverse relationship is
not established.
5. Long run vs. Short run: Friedman – it is
relevant for the short run and not the long run.
Prabha Panth

3. 3
Friedman - Long Run Phillip’s
curve
• Each short run Phillip’s curve is
drawn on the assumption of a
given expected rate of inflation.
• People experiencing inflation
expect further increase in
prices in future.
• This is called Adaptive
Expectations.
Prabha Panth

4. 4
Long Phillip’s curve
• On a given Phillip’s Curve, if government
follows expansionary policy, then
unemployment, but prices .
• Real wages , as prices rise, and labour
will demand higher money wages.
• Nominal wages increase, but
• Profits fall, and firms reduce employment.
• The PC now shifts upwards.
• Unemployment returns to N, the natural
rate of unemployment “r”.
Prabha Panth

5. 5
Long run Phillip’s curve
0
Inflation%
Unemployment
rate
PC1, 5%
N
A0
Inf =
5%
N0
Inf =
7%
A1
PC2, 7%
A2
Long Run PC
Long run Phillip’s curve is a
vertical line.
ON is the natural rate of
unemployment.
In the long run unemployment
remains at ON.
So only inflation occurs with
expansionary policies.
There is no trade off between
inflation and unemployment
Prabha Panth

6. 6
• Initially equilibrium is at A0 on PC1. Expected
inflation is 5%.
• Unemployment = ON (natural rate of
unemployment)
• Government increases jobs, through
expansionary policy.
• Unemployment falls to ON0, but inflation
increases to A1 = 7%.
• Real wages fall, expectation of more inflation.
• Demand for wages increases, employment falls
to ON.
• The PC shifts upwards to PC2,
• New equilibrium is A2, with higher inflation and 
unemployment back to ON.Prabha Panth

7. 7
Natural rate of unemployment
• In the long run there is no unemployment-
inflation trade-off.
• There will be a “natural rate of
unemployment” in the long run
• If Government tries to reduce
unemployment below natural rate, more
inflation will result.
• Therefore the long run PC will be a vertical
straight line at ON.
Prabha Panth

8. 8
NAIRU
• Any attempt to decrease unemployment below
ON, only leads to more inflation.
• Friedman – Government should not try to lower
unemployment below ON.
• ON is the critical level of unemployment =
frictional + structural unemployment.
• At ON, the rate of inflation will remain constant,
• Thus ON is the Non-accelerating Inflation rate of
unemployment. (NAIRU).
• It is the minimum amount of unemployment that
will ensure stable inflation rate.
Prabha Panth

9. 9
Criticism
• NAIRU theory against Keynes demand
management, and in favour of free
markets.
• No empirical basis for NAIRU.
• Unemployment may increase if workers
are paid higher wages for skills.
• If private jobs are not available,
Government may increase jobs.
Prabha Panth