Potential Trade offs between Objectivces

The Trade off between Unemployment and Inflation - The Philips Curve

The Philips curve is a graphical representation of the inverse relationship between the rate of inflation and the rate of unemployment in an economy.

The basic idea behind the Philips curve is that when unemployment is low, there is upward pressure on wages as employers compete for workers. This leads to higher labor costs, which are often passed on to consumers in the form of higher prices, or inflation. Conversely, when unemployment is high, there is less pressure on wages, and inflation tends to be lower.

However, the Philips curve has been subject to criticism and controversy over the years, as it has not always held up in practice. In particular, the curve has shifted and flattened at times, indicating that the relationship between inflation and unemployment is not as strong as originally thought. Additionally, the curve assumes a stable relationship between inflation and unemployment, but this relationship can change over time due to various factors such as changes in expectations, structural changes in the economy, or global shocks.

Short Run Philips Curve

In the above diagram we can see the original shape of the Phillips curve. This was the original relationship observed by William Philips in 1958. From studying the inflation and unemployment data from a number of different countries over a number of years he observed the following relationship.

When unemployment was low (U2) the inflation rate was high (In2) and when the unemployment rate was high (U1) the inflation rate was low (In1).

We can see this same relationship in the Keynesian model. When the real GDP was lower at Y1, the price level was Pl1. However, if Aggregate Demand was to increase from AD1 to AD2, resulting in an increase in real GDP, and decreasing unemployment. However, this led to an increase in the price level of the economy from Pl1 to PL2. As mentioned above, this most likely occurred because as unemployment rates decreased and labour become scarce, this pushed up wages as firms compete for the labour that is becoming more and more scarce. This in turn pushes up costs for firms, which may translate into higher prices for consumers.

The Phillips curve became an important tool for policymakers in the 1960s and 1970s as they sought to balance the goals of low inflation and low unemployment. The curve suggested that policymakers could use monetary and fiscal policy to trade off between inflation and unemployment. For example, if inflation was high, policymakers could raise interest rates or reduce government spending to cool down the economy and reduce inflation, but this would likely lead to higher unemployment. On the other hand, if unemployment was high, policymakers could use expansionary policies like lower interest rates or increased government spending to boost the economy and reduce unemployment, but this could lead to higher inflation.

The above trade off between unemployment held true for most of the 1960´s and formed the basis of Macroeconomic policies. However, events of the 1970s changed this view. With the creation of OPEC and the rapidly increase in the oil prices, many economies began to experience Stagflation, that is rising inflation (cost push inflation) with higher levels of unemployment.

Changes to the Short Run Phillips Curve

As mentioned above, the stagflation of the 1970s threw the original phillips curve theory into doubt. With both high inflation and high unemployment, the theory did not hold true. In the classical SRAS/AS diagram, we can see Stagflation caused by cost push inflation. Rising costs of production for firms causes a decrease in the overall levels of short run aggregate supply (SRAS1 to SRAS2). This causes an increase in the average price level from Pl1 to Pl2 and a fall in real GDP from Y1 to Y2, leading to a higher rate of unemployment.

Therefore in order to show this on the short run phillips curve, we show this with a shift outwards in the SRPC from SRPC1 to SRPC2, which shows an increase in both the rate of inflation from In1 to In2, and an increase in the unemployment rate from U1 to U2.

Long Run Philips Curve and the Monetarist View

The original Phillips curve dictated policies that involved governments intervening to manage the economy. If there was high levels of unemployment, governments would intervene with expansionary fiscal or monetary policy to stimulate the overall levels of aggregate demand and close a recessionary gap and vice versa. If the economy was experiencing high levels of inflation, contractionary policies such as raising taxes and cutting government spending or raising interest rates would be used to decrease the overall levels of Aggregate Demand. However, classical economists argue this will just led to inflation without growth.

As we have previously discussed, in the Classical/Monetarist view of the macroeconomy, the economy is always at its full potential (Yfe) in the Long Run and this is the Natural Rate of Unemployment in the economy. The natural rate of unemployment is the rate of unemployment that exists when the labor market is in equilibrium, meaning that there is neither a labor shortage nor a labor surplus. It is the rate of unemployment that exists when all factors of production are being used at their optimal level, and there is no cyclical unemployment caused by fluctuations in the business cycle.

From the classical view, there is no relationship between unemployment and inflation in the Long Run, therefore the Long Run Philips curve is fixed at the Natural Rate of Unemployment. In this example U1 represents the Natural Rate of Unemployment.

From the classical view, the economy is at Yfe. The government intervenes in the macroeconomy and increases spending. As a result, aggregate demand increases from AD1 to AD2. Real GDP increases from Yfe to Y2 and price levels rise from Pl1 to Pl2. We can see this in the SRPC from point A to B. Lower unemployment rate but higher inflation rate at In2. As we already know, this increase in the rate of inflation and average price level, will cause workers to demand higher wages to cover rising prices, increasing firms cost of production and as such, decreasing the SRAS from SRAS1 to SRAS2. This causes real GDP to fall back to the full employment level of Yfe and average price levels to rise from Pl2 to Pl3. In the Philips curve, this causes a shift outwards in SRPC from SRPC1 to SRPC2. As a result, unemployment returns to the Natural Rate of Unemployment at point C but now just at a higher rate of inflation.

This is the argument put forward by Classical or Monetarist economists as to why governments should not intervene in the macroeconomy to increase Aggregate Demand (as this will just lead to rising prices) and instead focus on increase the LRAS and long term growth by improving the quality and quantity of Factors of Production through Market Based Supply Side Policies.

Achieving both Low Unemployment & Low and Stable Inflation in the Long Run

Increasing the potential output of the economy will allow an economy to be able to achieve both low unemployment and low and stable inflation. This is because increasing the potential output from Yfe1 to Yfe2 requires an increase in the production capabilities of the economy as well as improving efficiencies and productivity of the economy. Being able to produce more will lower the overall price levels as well as require more labour, therefore reducing unemployment.

This will be looked at in more detail in the section looking at Macroeconomic Policy.

High economic growth and low inflation

High levels of economic growth driven by unsustainable use of resources, such as mining, can create a trade off between achieving economic growth and achieving environmental sustainability. Below we can see on the left a graph showing China´s GDP growth rate. On the right we can see the CO2 emissions for the same timeframe. This is an example of how there can be a trade off between high levels of economic growth and environmental sustainability. In order to grow its economy and shift to the secondary sector, China manufacturing boom also seen a large increase in its CO2 emissions.

Therefore, the question is, how do countries achieve high levels of economic growth and increased economic activity and improve the economic well being, whilst at the same time, preventing or limiting the external costs created from the negative externalities of production and overuse of common access resources.

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