A-Level Economics Notes on The Phillips Curve

Definitions

1. Phillips Curve: A graphical representation showing the inverse relationship between the level of unemployment and the rate of inflation.
2. Inflation: A sustained increase in the general price level of goods and services in an economy over a period of time.
3. Unemployment Rate: The percentage of the labor force that is jobless and actively looking for employment.
4. Wage Inflation: The rate at which the average salary of a population increases over time.
5. Trade-Off: A situation that involves losing one quality or aspect of something in return for gaining another quality or aspect.
6. Short-Run Phillips Curve: A curve that shows the trade-off between inflation and unemployment when expectations of inflation are constant.
7. Long-Run Phillips Curve: A curve that shows the relationship between inflation and unemployment when expectations of inflation have fully adjusted, typically vertical at the natural rate of unemployment.
8. Natural Rate of Unemployment: The level of unemployment consistent with a stable rate of inflation. It includes frictional and structural unemployment but not cyclical unemployment.
9. Expectations-Augmented Phillips Curve: A version of the Phillips Curve that takes into account the role of inflation expectations in the economy.
10. Rational Expectations: The theory that individuals and firms make decisions optimally, using all available information to forecast future economic variables.
11. Adaptive Expectations: The hypothesis that people’s expectations of future inflation are based on their experience of past inflation.
12. Stagflation: A situation in the economy where the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high.
13. Demand-Pull Inflation: Inflation that occurs when aggregate demand in an economy outpaces aggregate supply.
14. Cost-Push Inflation: Inflation caused by an increase in prices of inputs like labor, raw material, etc. The increased cost of the factors of production leads to a decreased supply of these goods.
15. Monetary Policy: The process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
16. Fiscal Policy: The use of government spending and taxation to influence the economy.
17. Supply Shock: An unexpected event that suddenly changes the supply of a product or commodity, resulting in a sudden change in its price.
18. Disinflation: A decrease in the rate of inflation – a slowdown in the rate at which prices are increasing.
19. Hyperinflation: An extremely high and typically accelerating rate of inflation, often exceeding 50% per month.
20. Policy Credibility: The degree to which economic agents believe that a government will stick to its policy announcements.

Introduction to the Phillips Curve

• Definition: The Phillips Curve is an economic concept that depicts an inverse relationship between the rate of unemployment and the rate of inflation within an economy.
• Historical Context: Named after economist A.W. Phillips, who first reported the phenomenon in 1958 after studying UK wage inflation and unemployment data from 1861 to 1957.

The Original Phillips Curve

• Empirical Observation: Phillips observed that with economic growth, wages tended to rise, and unemployment fell. Conversely, with economic decline, wages fell, and unemployment rose.
• Wage Inflation and Unemployment: The original curve related specifically to wage inflation, not price inflation, and unemployment.

The Adaptation to Price Inflation

• Expectations-Augmented Phillips Curve: Economists Milton Friedman and Edmund Phelps independently challenged the original Phillips Curve, arguing that it only held in the short run with constant inflation expectations.
• Long-Run Phillips Curve: They posited that in the long run, the curve is vertical, showing no trade-off between inflation and unemployment as expectations adjust.

The Short-Run Phillips Curve

• Trade-Off Concept: In the short run, policymakers can exploit the trade-off between inflation and unemployment: lower unemployment comes at the cost of higher inflation, and vice versa.
• Demand-Pull Inflation: Increased demand in the economy can lower unemployment but at the expense of higher inflation.

The Long-Run Phillips Curve

• Natural Rate of Unemployment: The long-run Phillips Curve suggests that there is a “natural rate of unemployment” where inflation does not accelerate or decelerate.
• Inflation Expectations: Over time, people adjust their expectations of inflation, which can neutralize the trade-off seen in the short run.

The Role of Expectations

• Rational Expectations: This theory suggests that people use all available information to predict inflation, which, in turn, influences their wage demands and price-setting behavior.
• Adaptive Expectations: This concept posits that past experiences of inflation are used to predict future inflation.

Criticisms and Relevance

• Stagflation: The phenomenon of stagflation in the 1970s, where high inflation and high unemployment occurred simultaneously, posed a significant challenge to the Phillips Curve theory.
• Policy Implications: The curve has been used to justify both expansionary and contractionary economic policies, depending on the prevailing economic conditions.

Shifts in the Phillips Curve

• Supply Shocks: Events like oil price shocks can shift the curve by affecting inflation directly, independent of unemployment.
• Changes in Expectations: As expectations of inflation change, the short-run curve can shift.

Policy Use of the Phillips Curve

• Monetary Policy: Central banks may use the relationship suggested by the Phillips Curve to set interest rates and control money supply.
• Fiscal Policy: Governments may adjust spending and taxation based on where they believe the economy sits on the curve.