Inflation – Unemployment Trade-Off — Phillips Curve

Inflation – Unemployment Trade-Off — Phillips Curve

Keynesian Explanation of Phillips Curve –

The explanation of Phillips Curve by the Keynesian economists is quite simple. Keynesian economists assume the upward sloping short run aggregate supply curve. Keynes himself recognized that the curve SAS is upward sloping in intermediate range, as the economy approaches near full employment level, the aggregate supply curve slopes upward.

According to Keynesian economists, short run aggregate supply curve is upward for two reasons.

First, as output is increased by the firms in the economy, diminishing returns to variable factors occurs resulting in fall in marginal physical product (MPP) of labour. With money wage rate as given and fixed, the fall in the marginal physical product of labour causes a rise in the marginal cost (MC) of production (MC = W/MPP_L). (W=Wage Rate).

With the fall in the MPP of labour, wage rate remaining constant, marginal cost (MC = W/MPP_L) will rise.

The second reason for the marginal cost to go up is the rise in the wage rate as employment and output are increased. When aggregate demand for output increases, demand for labour increases and wage rate tends to rise, supply curve of labour being upward sloping. Keynes believed that as the economy approaches near full employment, labour shortage might appear in some sectors of the economy causing increase in wage rate. So, marginal cost of firms increases as more labour is employed due to diminishing marginal physical product of labour and also because of wage rate also rises.

Phillips, while discussing the relationship between inflation and unemployment, considered the relationship between rate of increase in wage rate (as a proxy for the rate of inflation) on one hand and unemployment rate on the other.

It will be seen from panel (a) that with the initial aggregate demand curve AD₀ and the given aggregate supply curve SAS, the price level P₀ and output level Y₀ are determined.

Suppose the aggregate demand curve increases from AD₀ to AD₁, then price level will rise to P₁ and aggregate national output increases from Y₀ to Y₁. Increase in aggregate national product means increase in employment of labour and therefore reduction in the unemployment rate.

So, the rise in the price level from P₀ to P₁ (occurrence of inflation) results in lowering of unemployment rate showing inverse relation between the two. If aggregate demand increases to AD₂, the price level further rise to P₂, and national output increases to Y₂ which will further lower the rate of unemployment. The greater the rate at which aggregate demand increases, the higher will be the rate of inflation which will cause greater increase in aggregate output and employment resulting in much lower rate of unemployment.

So, a higher rate of increase in aggregate demand and consequently a higher rate of rise in price level is associated with the lower rate of unemployment and vice versa. This is what is represented by the Phipps Curve.

In panel (b) where point a’ on the downward sloping Phillips Curve PC corresponds to point a in panel (a). In panel (b) the rate of unemployment equals to U₃ corresponds to the price level P₀ of panel (a). When aggregate demand shifts to AD₁, there is a certain rate of inflation and price level rises to P₁ and aggregate output increases to Y₁. This increase in output leads to the increase in employment of labour which declines the unemployment rate.

Suppose the rate of rise in price level (rate of inflation) when it increases from P₀ to P₁ in panel (a) following the increase in aggregate demand is greater than the rate of rise in the price level of the previous period, we obtain a lower rate of unemployment U₂ than before corresponding to a higher inflation rate P₁ in the Philips curve PC in panel (b). With a higher rate of inflation, say P₂, when price level rises from P₁ to P₂ in panel (a) following the increase in aggregate demand to AD₂, we have a further lower rate of unemployment equal to U₁ in panel (b) corresponding to point c’ on the Phillips curve PC. Thus gives us a downward sloping Phillips curve PC.

Through increase in aggregate demand and upward sloping supply curve, Keynesians were able to explain the downward sloping Phillips curve showing the negative (trade-off) relation between rates of inflation and unemployment.