Annex (1):
The Phillips Curve
1/ What is the Phillips Curve?
• The Phillips curve is an economic concept developed by A. W.
Phillips saying that inflation and unemployment have a stable and
inverse relationship.
• In the short run there is a negative relationship between the
inflation rate and the unemployment rate.
• It is a curve that shows the short-run tradeoff between inflation
and unemployment.
• The theory claims that with economic growth creates inflation,
which lead to more jobs and less unemployment.
• how can we modify our existing theoretical model of the
macroeconomy to explain the inflation-unemployment tradeoff?
• graph 1: Phillips Curve
2/ Policy scenarios under Phillip curve
• Based on the aggregate demand and aggregate supply model
there are two possible outcomes that might occur.
- Figure 9/2a higher aggregate demand moves the economy to an
equilibrium with higher out-put and a higher price level.
- Figure 9/2b gives the same two outcomes using the Phillips curve:
- firms need more workers when they produce a greater output
of goods and services, unemployment is lower in outcome B
than in outcome A.
- when output rises from 7,500 to 8,000, unemployment falls
from 7 percent to 4 percent.
- Moreover, because the price level is higher at outcome B than
at outcome A, the inflation rate (the percentage change in the
price level from the previous year) is also higher.
- The two policy scenarios of possible outcomes available for the
economy either in terms of output and the price level or in terms
of unemployment and inflation (using the Phillips curve).
Figure 2: Two possible outcomes
3/ Labor market conditions and Phillip curve
 Figure 9/3 show a perfectly competitive labor market, the
intersection of the labor demand function and labor supply
function determines the equilibrium wage rate.
3 / Nominal Wage Inflexibility and the Short-Run
Phillips Curve
• Sticky wage rate:
• The strongest evidence is that
wages tend to move very slowly
over time. In Figure 9/4, wages
are not flexible at w*.
• In case of down sift in GDP and
demand for labor, a fall in
demand for labor lead to a fall in
total hours worked from n1 to
n2.
• But at the wage w*, the total
number of hours individuals
would like to work is still n1.
Figure 9/4
• Therefore, unemployment rises from zero to something strictly larger
than zero.
Cyclical unemployment has thus risen from zero to something strictly
positive due to the wage rigidity (also known as a sticky wage.
• To make our link between unemployment and inflation, we need to
consider what happens to inflation in this example. Recall that the
initiating event was a fall in aggregate demand, which means that the
overall price level of the economy must fall (holding fixed the aggregate
supply function).
• A decline in the price level means, by definition, that inflation has
decreased. Thus, the rise in unemployment is accompanied by a fall in
inflation – precisely the relationship we set out to model.
• This negative relationship between the inflation rate and the
unemployment rate is captured by the Phillips Curve, depicted in Figure
9/5.
• The Phillips Curve depicts the short-run negative relationship between
the inflation rate and the unemployment rate.
4/ The Long-Run Phillips Curve
• In the 1970s, many countries
experienced high levels of both
inflation and unemployment also
known as stagflation.
• If inflation is reduced from two to
zero percent, unemployment will be
permanently increased by 1.5
percent. This is because workers
generally have a higher tolerance
for real wage cuts than nominal
ones.
Figure 5: Phillips Curve
• Figure 9/4, suppose that after some period of time with the wage stuck at
w* and unemployment above its natural rate, new rounds of wage
negotiation yield the lower nominal wage w* in Figure 9/4.
• At this lower wage, cyclical unemployment is back down to zero, implying
that the unemployment rate is back to its natural rate. This occurs even
though aggregate demand remains at its reduced level – that is, even
though inflation stays low, unemployment will eventually move back to its
natural rate.
• This long-run relationship is embodied in the vertical long-run Phillips
Curve shown in Figure 9/6.
• After a protracted length of time during which the wage remains stuck
above the market-clearing wage, it is likely that firms will win wage
reductions in the next round of wage negotiations. A decrease in the wage
from w* to new thus lowers cyclical employment back to zero and hence
the unemployment rate down to the natural rate.
• In the long-run, there is likely to be no trade-off between
inflation and unemployment because in the long-run wages
will adjust. This idea is embodied in the vertical long-run
Phillips Curve.
Figure 9/6: long run Phillip curve