Economics Department

Phillips' curve

"A relationship between the rate of wage increase and unemployment, plotted by the British economist A. W. Phillips (1914-75) in 1958. The Phillips' curve suggested that the UK Government had an option between unemployment and inflation, i.e. it could achieve a little less of one if it was prepared to accept a little more of the other. The hold that the relationship is theoretically unsound and it has indeed broken down in practice since 1966."

The Macmillan Encyclopedia 2001, © Market House Books Ltd 2000

1) To what extent does a Phillips Curve type relationship appear to hold for the UK Economy between 1975 and 2000?

5 marks

2) According to Economic theory, will there be a trade-off between unemployment and inflation in the long run.

8 marks

3) Using diagrams to illustrate your answer, analyse the actions that the government could take to improve the trade-off.

6 marks

The Expectations Augmented Phillips Curve

The article below is taken from http://www.scottishlife.co.uk/scottishlifeold/invest/jargon5.htm

Interpreting the Philips Curve one can identify what is sometimes referred to as the natural rate of unemployment, point U on the curve. This is the rate of unemployment below which the economy will experience inflationary pressures. Put simply, below these levels of unemployment there will be short supply of labour and consequently employers will drive wages upwards to attract new staff. Higher wages lead to higher costs and higher demand and consequently inflation.

However in the 1970’s the existence of both rising inflation and rising unemployment at the same time (sometimes called "stagflation") called this relationship into question. Milton Friedman, an influential US economist, reinterpreted the curve and produced the "Expectations Augmented Phillips Curve".

A simple way to understand this version of the curve is to consider employees expectations of inflation. In the short term, before labour market expectations adapt, demand management is effective. However, at some point in the future, price expectations adapt.
If inflation is expected to be, for example, 10% then workers who demand a real increase in wages will demand wage rises above 10%. As a consequence in the long term the economy tends to settle at the original unemployment level but with a higher level of prices.

4) How valid do you feel the expectations augmented Phillips' curve to be?

7 marks

Inflation and Government
When the Thatcher government took power in 1979 one of their main aims was to reduce the level of inflation. To achieve this they operated a tight monetary policy and announced a public commitment to low money supply growth targets.

In short, as the labour force realised that higher wage claims would only result in them "pricing themselves out of a job" wage claims and expectations of inflation were reduced and for the short term at least inflation was moderated.

Nowadays, Keynesian economics has lost many of its loyal supporters and the belief that the manipulation of government policy can lift economic growth and result in full employment has disappeared across the political spectrum.
Of course, alternatively, Mr Keynes may just be taking the blame for the politicians policy errors

5) To what extent do you feel that Keynesian Economics was to blame for the stagflation of the late 1970s?

7 marks

6) How successful was the monetarist experiment of the 1980s, described in the passsage above?

7 marks

7) Describe the differences in NAIRUs shown in the table.

3 marks

8) Analyse the factors that make the NAIRU lower than the UK in countries such as the US, Japan, Norway and Switzerland, but much higher in countries such as Spain, Finland, Italy and France.

7 marks

For further reading on the problems with estimating the NAIRU, and the extent to which it can be used in setting economic policy, go to:

http://www.cepr.net/alan_greenspan_and_the_ecb.htm

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