The Philips Curve

Aims and Objectives Aim:  Understand Philips curve and the augmented Philips curve Objectives:  Define Philips Curve Trade Off  Explain demand and supply side policies which could be used to reduce unemployment  Analyse the usefulness of the Philips Curve  Evaluate the augmented Philips curve

Starter ‘The appropriate response to combat cyclical unemployment may be to stimulate AD. The supply side nature of unemployment needs to be tackled with supply side policies.’ What demand side & supply side policies can you think of to combat unemployment?

Demand Side & Supply Side Policies Demand Side Fiscal PolicyMake Credit More Available Use regional policy to combat structural unemployment Offer firms subsidies to hire workers in depressed regions Supply Side Improved education Increase funding on vocational training Subsidise housing in cities where accommodation is expensive Provide tax breaks and tax credits

The Philips Curve AW Philips plotted data Short run trade off between unemployment and inflation Falling unemployment might cause inflation to rise Reducing inflation might only be at the expense of increasing unemployment Inverse relationship

The Philips Curve Level of inflation could be traded off against a level of unemployment. Will happen as to reduce unemployment AD must be stimulated which will lead to inflation when there is excess demand/ Inflation % Unemployment % SRPC

The Philips Curve 1970s high inflation and unemployment co-existed – stagflation. On graph paper plot the following data for unemployment and inflation from Does there appear to be any obvious relationship, or had the Philips curve trade off truly broken down?

The Philips Curve Year Unemployment % of Workforce Inflation % Change %5.90% %8.70% %6.50% %8.40% %17.00% %23.50% %15.70% %14.70% %9.50% %13.70% %16.30% %11.20% %8.70% %4.80% %5.00% %5.30%

The Philips Curve Does there appear to be any obvious relationship, or had the Philips curve trade off truly broken down?

Produce yourself a set of teaching notes and the Philips Curve. You are then to have an economist speed dating session. You will have 3 minutes to tell your hot date all about Philips Curve in an attempt to ‘woo’ them with economics knowledge. Your date will then score you out of ten.

The Expectations Augmented Philips Curve

Aims and Objectives Aim:  Understand Philips curve and the augmented Philips curve Objectives:  Define Philips Curve Trade Off  Explain demand and supply side policies which could be used to reduce unemployment  Analyse the usefulness of the Philips Curve  Evaluate the augmented Philips curve

The Expectations Augmented Philips Curve Monetarist economists were still adamant that the curve existed. Milton Friedman accepted that there is a short run Philips Curve but that in the long run it was vertical. He suggested that it’s impossible to reduce unemployment in the long run by, for example, increasing the money supply as this will just cause inflation.

The Expectations Augmented Philips Curve You are walking down a street on your own, you know is a ‘bit dodgy’ to get home after a night out. In this street you are mugged and your phone and wallet/purse is stolen and you are left with a black eye. The next week you go out again and have the choice of walking down the same street having been,mugged or going down an alternative street. What do you do?

The Expectations Augmented Philips Curve Adaptive expectations: where decisions about the future are based upon past information. If consumers experience high inflation in one month, they will learn from this and demand higher wages in the next period. The result may be that higher unemployment is required to keep inflation at a target level. Credible monetary policy may also have the effect of reducing inflation expectations, causing a leftward shift of the SRPC.

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5%

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% Economy initially at point A, unemployment at natural rate UN At point A the rate of inflation is 0

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% We assume that people form expectations of future inflation on the basis of the current rate of inflation. Since current inflation is zero, workers expect future inflation to also be zero.

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% Gov. stimulates AD – movement along the SRPC1 to Pt B. Unemployment – U1 and inflation rising to 5%. Pt B is unsustainable.

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% For workers to supply more labour the RWR must rise. In short run more workers may supply themselves, suffering from money illusion. Believing that a 5% increase in wages is also a real increase.

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% For workers to supply more labour the RWR must rise. In short run more workers may supply themselves, suffering from money illusion. Believing that a 5% increase in wages is also a real increase.

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% Firms may also suffer from money illusion believing that rising prices mean sales revenues are rising faster than labour costs. Workers and firms eventually see through money illusion and refuse to supply and demand labour.

The Expectations Augmented Philips Curve Inflation % Unemployment % SRPC1 SRPC2 LRPC C B U1 UN A 5% Economy now moves to point C but with inflation expectations of 5% now built in. Any attempt to boost AD, will result in a movement along SRPC2 and a return the NRU.

The Expectations Augmented Philips Curve The EAPC suggests that there is no long-run trade off between inflation and unemployment as the LRPC suggests. Any attempt to reduce unemployment below NRU by stimulating AD is pointless and governments must tackle supply side causes if they wish to reduce unemployment. NRU = voluntary frictional unemployment NAIRU= non accelerating inflation rate of unemployment the level of U where I does not increase.

The Long Run Philips Curve Can shift inward over time. Due to supply side improvements in the economy Labour market reforms may lead to a reduction in the NRU & NAIRU by improving occupational mobility of labour

Produce yourself a set of teaching notes and the EAPC. You are then to have an economist speed dating session. You will have 3 minutes to tell your hot date all about EAPC in an attempt to ‘woo’ them with economics knowledge. Your date will then score you out of ten.