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MACROECONOMIC
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12. Introduction to Philips Curve, Keynesian Explanation of the Phillips Curve
ANS:
Economic growth without inflation and unemployment is the objective behind macro-economic policies of modern times. However, in the short term, there seems to be a trade-off between inflation and unemployment and hence macro-economic policy 47 makers need to balance between inflation, economic growth and unemployment. A low inflation rate is seen to accompany lower economic growth rate and higher unemployment whereas a high
inflation rate is seen to accompany higher economic growth rate and lower unemployment. Here, in this chapter, we look at the Phillips curve which was the first explanation of its kind to show the negative relationship between unemployment and inflation rate.
Economic growth without inflation and unemployment is the objective behind macro-economic policies of modern times. However, in the short term, there seems to be a trade-off between inflation and unemployment and hence macro-economic policy 47 makers need to balance between inflation, economic growth and unemployment. A low inflation rate is seen to accompany lower economic growth rate and higher unemployment whereas a high
inflation rate is seen to accompany higher economic growth rate and lower unemployment. Here, in this chapter, we look at the Phillips curve which was the first explanation of its kind to show the negative relationship between unemployment and inflation rate.
We
also look at the long run picture and see whether the negative relationship
sustains in the long run.
The explanation of Phillips curve by the Keynesian economists is shown in Fig. 2A.2. Keynesian economists assume the upward sloping aggregate supply curve. The AS curve slopes upwardly due to two reasons. Firstly, as output is increased in the economy, the law of diminishing marginal returns begins to operate and the marginal physical product of labor (MPPL) begins to decline. Since the money wages are fixed, a fall in the MPPL leads to a rise in the marginal cost of production because MC = W/ MPPL. Secondly, the marginal cost goes up due a rise in the wage rate as employment and output are increased. Following rise in aggregate demand, demand for labor increases and hence the wage rate also increases. As more and more labor is employed, the wage rate continues to rise and the marginal cost of firms increases.
The explanation of Phillips curve by the Keynesian economists is shown in Fig. 2A.2. Keynesian economists assume the upward sloping aggregate supply curve. The AS curve slopes upwardly due to two reasons. Firstly, as output is increased in the economy, the law of diminishing marginal returns begins to operate and the marginal physical product of labor (MPPL) begins to decline. Since the money wages are fixed, a fall in the MPPL leads to a rise in the marginal cost of production because MC = W/ MPPL. Secondly, the marginal cost goes up due a rise in the wage rate as employment and output are increased. Following rise in aggregate demand, demand for labor increases and hence the wage rate also increases. As more and more labor is employed, the wage rate continues to rise and the marginal cost of firms increases.
You
may notice that in Panel (a) of Fig.2A.2 that with the initial aggregate
demand curve AD0 and the given aggregate supply curve
AS0, the price level P0 and output level Y0 are determined. When
the aggregate demand increases, the AD0 curve shifts to the right
and the new aggregate demand curve AD1 intersects the aggregate
supply curve at point ‘b’. Accordingly, a higher price level
P1 is determined along with a rise in GNP to Y1 level.
With the increase in the real GNP, the rate of unemployment falls to U2. Thus, the rise in the price level or the inflation rate from P0 to P1, the unemployment rate falls thereby depicting an inverse relationship between the price level and the unemployment rate.
With the increase in the real GNP, the rate of unemployment falls to U2. Thus, the rise in the price level or the inflation rate from P0 to P1, the unemployment rate falls thereby depicting an inverse relationship between the price level and the unemployment rate.
Now
when the aggregate demand further increases, the AD curve shifts
to the right to become AD2. The new aggregate demand curve
AD2 intersects the aggregate supply curve at point ‘c’.
Accordingly,
the price level P2 and output level Y2 is determined. The
level of unemployment now falls to U3. In Panel (b) of Figure 2A.2,
points a, b and c are plotted and these points corresponds to the
three-equilibrium points a, b and c in Panel (a) of the figure. Thus,
a higher rate of increase in aggregate demand and a higher rate
of rise in price level are related with the lower rate of unemployment
and vice versa. The Keynesian economists were thus
able to explain the downward sloping Philips curve showing inverse
relation between rates of inflation and unemployment.
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