·
The Phillips curve shows the short
run trade off between unemployment and the rate of inflation (see July's post).
·
As unemployment falls, inflation rises.
Both demand-pull and cost-push inflation can rise due to low unemployment.
·
Demand pull: When more people are in
employment, more people have more spending money. Thus consumption increases,
leading a shift of the AD curve to the right and a rise in the price level.
·
Cost push: Low unemployment means there is a
smaller pool of labour for employees to choose from. This increases trade union
bargaining power for higher wages (see here) and thus increases wage inflation.
Because it costs firms more to produce the same level of output, they raise the
price of the goods they produce to pass on this extra cost to consumers,
contributing to a higher rate of inflation.
·
The trade-off illustrates the difficulty faced
by policy makers and the government are faced with choosing the most suitable combination of inflation and
unemployment rather than completely eliminating/reducing one of them.
·
The Phillips curve is still debated among many
economists as they feel it does not hold. One of the criticisms of the Phillips curve is
that in the 1970s (use this as a case study in the exam!!), inflation and
unemployment were rising at the same time and there was no trade off. This was
called stagflation/slumpflation (see Word of the Day in August).
The Phillips Curve relates to the quantity theory of money, so, if you have forgotten why, refresh your memory by clicking here!
In the long run, there is NO trade off between inflation and unemployment, shown in the
diagram below.
NRU is the Non-accelerating inflation Rate of Unemployment.
This means that it is the only rate of unemployment that the inflation rate
does not change, the natural rate of
unemployment. It is also known as the equilibrium level of unemployment.
