TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 20

Is there any relationship between inflation

and unemployment?

Unemployment and Inflation

Society faces a short-run tradeoff between unemployment and
inflation.
If policymakers expand aggregate demand, they can lower
unemployment, but only at the cost of higher inflation.
If they contract aggregate demand, they can lower inflation, but at
the cost of temporarily higher unemployment.

The Phillips Curve

In 1958 A.W. Phillips published a study of
wage behavior in the U.K. between 1861 and
1957
The main findings are summarized in
Figure
There is an inverse relationship between
the rate of unemployment and the rate of
wage inflation
From a policymakers perspective, there
is a tradeoff between wage inflation and
unemployment

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The Original Phillips Curve Paper

The Phillips Curve

Inflation
Rate
(percent
per year)
B

Phillips curve
0

Unemployment
Rate (percent)

Phillips Curve
The PC shows the rate of growth of wage inflation decreases with
increases in unemployment
If Wt = wage this period
Wt 1 Wt
Wt+1 = wage next period
gw
gw = rate of wage inflation, then
Wt
*
g

(
u

u
)
PC is defined as: w

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u* is the natural rate of unemployment

measures the responsiveness of wages to unemployment
u is the actual unemployment
(u - u*) is called the unemployment gap

Phillips Curve
Suppose the economy is in equilibrium with
prices stable and unemployment at the
natural rate

To see why this is so, rewrite equation (1)

in terms of current and past wage levels:

If money supply increases by 10%, wages

and prices both must increase by 10% for
the economy to return to equilibrium

Wt 1 Wt
(u u * )
Wt

PC shows:

Wt 1 Wt Wt ( (u u * ))

If wages increase by 10%, unemployment

will fall
If wages increase, price will increase and
the economy will return to the full
employment level of output and
unemployment

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Wt 1 Wt ( (u u * )) Wt
Wt 1 Wt [1 (u u * )]
For wages to rise above previous levels, u
must fall below the natural rate

Aggregate Demand, Aggregate Supply, and the

Phillips Curve
Aggregate
Demand, Aggregate Supply, and the Phillips Curve
The Phillips curve shows the short-run combinations of
unemployment and inflation that arise as shifts in the aggregate
demand curve move the economy along the short-run aggregate
supply curve.
The greater the aggregate demand for goods and services, the greater
is the economys output, and the higher is the overall price level.
A higher level of output results in a lower level of unemployment.

How the Phillips Curve is Related to Aggregate Demand

and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
Price
Level

102

Inflation
Rate
(percent
per year)

Short-run
aggregate
supply

106

A
High
aggregate demand
Low aggregate
demand

(b) The Phillips Curve

7,500 8,000
(unemployment (unemployment
is 7%)
is 4%)

Quantity
of Output

2
Phillips curve
0

4
(output is
8,000)

Unemployment
7
(output is Rate (percent)
7,500)

Shifts in the Phillips curve: the role of expectations

The Phillips curve seems to offer policymakers a menu of possible
inflation and unemployment outcomes.

The Policy Tradeoff

PC originally defined as trade-off between
wage inflation and unemployment
Can be applied more generally to the trade-off
between inflation and unemployment
PC cornerstone of macroeconomic policy
analysis
Can choose low u if willing to accept high
(late 1960s)
Can maintain low by having high u (early
1960s)

In reality the tradeoff between u and is a

short run phenomenon
In the Long Run the trade-off disappears as AS
becomes vertical
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The Inflation Expectations-Augmented

Phillips Curve

If maintaining the assumption of a constant real wage, W/P, actual

will equal wage inflation

The equation for the modern version of the PC, the expectations augmented
PC, is:
g w e (u u * )

e (u u * ),
e (u u * )
NOTE:

1. e is passed one for one into actual

2. u = u* e =
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