Home > Macro, Phillips Curve > The trade-off between inflation and unemployment

The trade-off between inflation and unemployment

The basic idea behind the Phillips Curve is that of a ‘trade-off’ between inflation and unemployment. The trade-off generally holds in the short-run but not in the medium-run. I think the Phillips Curve becomes easier to understand if you start from the concept of a natural rate of unemployment, which will be the opposite of the rate of employment that corresponds to a natural level of output in the economy. This natural level will be determined by supply factors.

When unemployment is lower than the natural rate of unemployment, then it means output is above the natural rate of output, and more workers need to be hired to produce the extra output. This is what will happen if the government uses some form of expansionary policy (fiscal or monetary) to stimulate the economy and push the level of output up above its natural level.

Because unemployment is now lower than the natural rate, it means workers are becoming more scarce, so firms need to pay more wages to hire them and keep them from moving on to rivals. The labour market becomes more of a ‘sellers’ market – the sellers of labour (workers) have the advantage because workers are scarce and jobs are abundant, so wages are bid up. This leads to an increase in firms’ costs, which are passed on to consumers through the price-setting equation. The increase in prices then leads to an increase in expectations of future prices being higher, which will transfer into higher wage demands at the next round of wage bargaining. So the wage-price spiral causes prices to rise faster.

When unemployment is higher than the natural rate, you have the opposite situation, it means output is below the natural level of output and fewer workers are needed. The labour market
is a ‘buyers’ market, the buyers of labour (firms) have the advantage because jobs are scarce and unemployed workers are abundant. This will drive down wages and so firms can pay only small wage increases or maybe no increases at all, which keeps their costs from rising and allows them to keep prices lower (to compete with their rivals). This will act as a brake on inflation, so prices will either be stable, rise slowly (more commonly), or if unemployment is very high compared to normal, prices can be driven lower (deflation).

Remember that although classical economic theory allows for prices to be flexible up and downwards, in practice, you don’t tend to see prices falling downwards very often unless there is a very bad recession. Most workers will be on strike at the first sniff of a nominal pay cut, so when wages need to adjust downwards they tend to do so over a few years, with pay freezes or below inflation pay rises, so that wages end up falling in real terms over a few years. So we don’t tend to equate low unemployment with rising prices and high unemployment with falling prices, in practice it is more like low unemployment means fast rising prices (high inflation) and high unemployment means slowly rising prices (low inflation).

This inverse relationship between inflation and unemployment allows the option of a trade-off (in the short run) for policy makers between inflation and unemployment, it says they can reduce unemployment temporarily by stimulating the economy, but the downside is that it will bring in extra inflation. This is the basis behind the idea of the (short-run) Phillips Curve.

Here you have two choices. In the short run you can accept unemployment level u1 and inflation level \pi 1 at point A or you can move to point B where you lower unemployment to u2 at the cost of higher inflation level \pi 2.

The Phillips Curve is downward sloping because unemployment is negatively related to inflation, so a change in unemployment or a change in inflation is represented by a movement along the Phillips Curve. But the wage-setting relation also included expected prices as well as the rate of unemployment. When expected prices are higher, wage demands will be higher at all levels of unemployment. This would be represented by shifting the whole Phillips Curve up. Changes in expected prices shift the Phillips Curve up or down.

So to sum up, the (short-run) Phillips Curve is downward sloping.
The whole curve shifts up if price expectations rise. This has an important implication, because it means that when you move up the curve, and have higher inflation, then if workers adjust their expectations of prices upwards, it means you won’t just move up the curve to get your lower unemployment, but the curve will start to shift upwards as well.
The curve shifts down if price expectations fall.

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Categories: Macro, Phillips Curve
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