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A Phillips curve shows the inverse relationship between the unemployment rate and the rate of inflation in an economy. According to Colander (1995), it can make an association between the nominal variables such as the price level, the wage rate, the inflation rate and between the other components of the real economy. More specifically, it can be stated that the Phillips curve can derive the changes of nominal income and how it would decompose the changing of quantities as well as the price level of the goods. Therefore, in terms of economics, the nature of Phillips curve can determine the reflection of the interaction of demand and supply on the economy and how it would affect the real and the nominal variables of the economy, so that the policymakers would also be affected. Before discussing the importance of Phillips in the orthodox economy, it is necessary to describe the discovery behind its origin.
In the opinion of Forder (2010), A. W. Phillips, the economist of the London School of Economics, had discovered the concept of this curve in the year 1950, while he was engaging with the Keynesian analytical framework. As per the Keynesian theory, during the period of recession, the inflationary pressure is much lower. However, if the output of the economy would start to push the potential GDP, then the economy would face greater challenges. During this period, Phillips found that the inflation rate of a country is inversely related with the rate of unemployment of the country. In this context, he collected 60 years information of the UK and hence, his propounded theory is referred as Phillips curve and has started to describe in the Keynesian economy.
Figure 1: Phillips curve
(Source: Glyn, 2006)
In the opinion of Palley (2005), derivation of the typical aggregate supply curve is associated with Phillips curve. However, during the period of great depression, the period during the year 1929- 1932, the classical view on the Phillips curve had changed. When the policymakers would start to exploit the adverse relationship among the unemployment and the inflation rate, then under the fiscal policy and monetary policy, the Phillips curve would be move up or move down. As per the concept of classical economics, real output is dependent upon the supply side economy, which in turn rely upon several factor of production and these are labour, capital and the productivity. Therefore, with the changes of demand for the products would directly affect the price level and also the inflation rate. However, Helleiner (1994) argued that in the classical economy, the Phillips curve would not be able to describe the relationship between the rate of unemployment and the change of the money wage rate. Apart from this, in the orthodox Keynesianism, the concept of classical dichotomy as well as the monetary neutrality would not be hold with the changing of money supply and also with the shifting of nominal demand. Furthermore, monetary policy would not have real effect in the orthodox Keynesian period. In this context, Coibion and Gorodnichenko (2015) stated that the effect of monetary policy on the money supply would affect the demand and hence, the price level would be changed. This was the reason, why both the concept of monetary neutrality and classical dichotomy would be abolished in the neo-classical period.
In the neo-classical synthesis, it can be mentioned that the Phillips curve can establish the relationship between the rates of inflation with the changing of the real economic activities. However, this concept was against the concept of Phillips curve, which was found in the year 1958. In the orthodox Keynesian, the Phillips curve would formulate the statistical relationship between the percentage changes in the nominal wage rate and the rate of unemployment. More specifically, Phillips curve would derive an inverse association between the wage inflation and the unemployment rate as the proxy of the relationship of price inflation and the real output of the classical period. Therefore, aggregate supply (AS) curve has positive and finite slope, which would be related with the negatively sloping Phillips curve. It would in turn develop a positive relationship between the output level and the rate of inflation. In case of equilibrium position of the labour market, then the nominal wage rate would not be changed. With the rise of aggregate demand, it would increase the labour demand and hence, the rate of unemployment would be declined below the level of equilibrium. Consequently, the nominal wage rate of the employees and the price level would be increased. Therefore, Galí (2011) cited that the negative slope of the Phillips curve is the reflection of the excess demand of labour and the lowering unemployment rate. On the other hand, the wage inflation would also be increased. From this point, it can be stated that the neoclassical synthesis is the effect of pre-Keynesian neoclassical theory as well as the Keynesian macroeconomics. This theory was criticised by Richard Lipsey (1960) and stated that the neoclassical micro theory was converted into the macroeconomics and was referred as demand pull theories. He also stated that under the labour market disequilibrium position, wage inflation is dependent upon the distinction among the labour demand and the supply of labour (Gordon, 2011).
The expectations augmented Phillips curve has initiated adaptive expectations in the Phillips curve. In the opinion of Correa and Minella (2010), the expectations augmented Phillips curve was initially used for explaining the monetarist view. The expectations augmented model would lead to the shift of government ability to act. Moreover, under the Keynesian money illusion, the changes of nominal variables such as the price level and the wage rate as well as the purchasing power would be stable. As a result, if the government would decide to rely on the expansionary monetary policy, then the unemployment rate would be declined and the inflation rate would be increased. On the other hand, both Phelps and Friedman had argued that the government would not trade at the high rate of unemployment for lowering down the unemployment rate. Both the economists mentioned that the real wage rate is constant. In this context, the government would use both the fiscal or monetary policy in order to lowering down the rate of unemployment under the natural rate. As a result, increase in demand would increase the price level compared to the anticipation rate of the employees. For instance, in case of higher revenues, the organisations would like to employ more employees at the similar wage rate. In case of rising of money wage rate, the organisations would stop to supply more labours. This is the reason, why the rate of unemployment would be declined. Furthermore, the purchasing power would be decreased with the reduction of purchasing power. On the contrary, Daly and Hobijn (2014) argued that with the passage of time, and in case of higher price inflation, the organisations would like to supply less labour and would create pressure to maximise the wage rate in order to align with the inflation rate. Therefore, it can be inferred that both the presence of price inflation and wage inflation would sustain expansionary fiscal policies at the higher rate.
Both the economists, Phelps and Friedman, also highlighted the diversification among the long run and short run Phillips curve. As per the concept of Phillips curve of 1960s, the average inflation rate would be constant, where the inflation rate and the rate of unemployment are inversely associated. However, with the changes of average inflation rate, the policymakers would continuously try to push down the rate of unemployment below the natural rate (Correa and Minella, 2010). Therefore, if the perception of the workers would be similar with the real values, then the natural unemployment rate would be compatible with the inflation rate. Therefore, the long run Phillips curve would be vertical and it would be above the natural rate. Nonetheless, in the transitional phase, it can be observed that the average rate of inflation would be shifted persistently (Mavroeidis, Plagborg-Møller and Stock, 2014). More specifically, it can be stated that both the long run as well as short run is the combination of expectations augmented Phillips curve. The unemployment rate would be returned to its natural rate when the expectation of the workers towards the price inflation would adapt the changes of actual inflation rate.
On the contrary, Mavroeidis, Plagborg-Møller and Stock (2014) argued that the trade-off among the unemployment rate and the inflation rate, which would be explained with the help of Phillips curve, had broken down during the stagflationary period of 1970. During this period, both the unemployment rate and the rate of inflation had been increased rapidly. As per the statement of the monetarists, the rising of money supply would lead to increase the wage inflation and it would not reduce the unemployment rate. As per the statement of Milton Friedman, the trade-off relationship does not hold among the inflation rate and the unemployment rate in the long run.
Figure 2: The shifts of Phillips curve during 1970 to 1979
(Source: Labour statistics of the US bureau)
According to Kuttner and Robinson (2010), the inflation rate had increased from 2.5 percentage in 1960 to 7 percentage in 1970. Consequently, during this period, the unemployment rate would decrease from 4 percentages to 6 percentages during this period. This situation was described as non-accelerating inflation rate of unemployment rate (NAIRU). Nevertheless, it can be criticised that the trade-off between the rate of inflation and the unemployment rate was still exist during this period and hence, the Phillips curve just shifted towards the rightwards. In this connection, it can be stated that the shifted Phillips curve showed the worsen trade-off due to the occurrence of cost-push inflation (Coibion and Gorodnichenko, 2015). On the other hand, the modern macroeconomic theories show that version of Phillips curve can minimise the output gap by replacing the unemployment rate since it is the measurement of aggregate demand comparative to the aggregate supply.
Figure 3: Shifted Phillips curve
Source: Coibion, 2010
According to Gallegati et al., (2011), the UK had born the risks due to the occurrence of painful stagflation and was continued to the year 2010. During this period, the unemployment rate and the oil price across the country had been increased sharply. As a result, the growth rate of the economy of the UK is sluggish. However, Dua and Gaur (2010) stated that the situation was not recessionary. The stagflation would lead to make the borrowing highly expensive. Consequently, the slower growth rate would maximise the percentage of job losses very high. The rise of the gasoline price was the resultant of oil supply shock and hence, the price level of the products across the country had been increased. The situation was referred as the cost push inflation.
Before discussing the consequences of the stagflation on the UK market, it is necessary to highlight the reason of occurrence of stagflation. As per the statement of Mazumder (2010), under the constant supply of the economy, the central bank of the economy would like to expand the money supply. Stagflation occurs when the government would print more currency. In addition, the central banks would aim to create more credit. Consequently, the money supply and the money supply would be increased.
As per the concept of the Keynesian theories, the inflation rate is inversely related with the unemployment rate as well as is positively related with the growth of the economy. In 1970, the rising price level and the rising unemployment rate would be the resultant of cost push inflation and hence, the oil price would be increased (Granger and Jeon, 2011). The monetary policy was also expensive in this period. Apart from the monetary policy, the export and the import behaviour of the country had been affected due to the stagflationary situation.
It is known that stagflation occurs due to the higher inflation and the higher unemployment rate. It prevents the growth rate of the economy. In the opinion of Jean-Baptiste (2012), after the occurrence of the stagflation in 1970, the federal government had started to manipulate the currency in order to spur the growth rate of the economy. The stagflation during the period of 1973 to 1975 was referred as the situation of recession. In the global economy, the unemployment rate had reached to the highest peak in the year 1975 and was stuck at 9 percentages. The inflation rate also reached to 9.6 per cent from 3.4 per cent in 1973 (Rumler and Valderrama, 2010; D'Arista, 2009). Apart from this, the global GDP was negative since last three quarters of 1970.
During the stagflationary period, the US government had implemented three fiscal policies. Firstly, Nixon, the US president of that period, had frozen the wage level and the price rate for 90 days. After that the price commission and pay board had developed for increasing the wage and price after 90 days. This was beneficial to control the price level after the year of 1972. This was the effective approach of controlling the global inflation rate. Secondly, Nixon had planned to impose 10 percentage of tariff on the imports. He aimed at lowering down the balance of trade for protecting the domestic firms. In addition, he increased the price of the importable. Thirdly, Nixon had removed the system of gold standard. It would help to keep the value of dollar at the fixed rate since the year 1944. In order to worsen the stagflation, the fed government had increase the funds rate between the period of 1971to 1978 (Imbs, Jondeau and Pelgrin, 2011; Snowdon and Vane, 2005). It had helped to increase the price level and hence, the inflation rate has increased up to 13.3 percentages in the year of 1989.
As per the statement of Carlin and Soskice (1990), during the post war displacement period of Keynesianism, the Keynesian economics would lead to develop developed world. The developed world would be structured by the influence of economic policies, which had adopted by the emerging countries. The policy makers were driven by the Keynesian thinking and followed the free market policies instead of formulating the mixed economy since unnecessary government intervention was required in this context. As a result, the world economy had been experiencing a long boom by the prior period of 1970 (Glyn et al., 1986). In addition, in the year 1965, the advanced capitalists countries had experienced persistent inflation rate.
Based on the analysis, it can be mentioned that the Phillips curve was derived based on stable and inverse relationship of the inflation rate and the unemployment rate. This theory claims the economic growth rate, which would in turn create more jobs, which would in turn reduce the unemployment rate. However, as per the concept of expectation augmented Phillips curve, the Phillips curve would not be sustained in the long run. Therefore, it can be inferred that the Phillips curve would be broken down. On the other hand, Friedman also made a counter argument and stated that in the long run, the Phillips curve would be shifted in the right ward. Apart from this, based on the analysis it can be observed that during the stagflationary period of 1970, the trade-off among the unemployment rate and the inflation rate would be broken down and hence, both the unemployment rate and the inflation rate had increased in this period.
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