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The Phillips curve examines the relationship between the rate of unemployment and the rate of money wage changes. Known after the British economist A.W. Phillips who first identified it, it expresses an inverse relationship between the rate of unemployment and the rate of increase in money wages. Basing his analysis on data for the United Kingdom, Phillips derived the empirical relationship that when unemployment is high, the rate of increase in money wage rates is low. This is because “workers are reluctant to offer their services at less than the prevailing rates when the demand for labour is low and unemployment is high so that wage rates fall very slowly.” On the other hand, when unemployment is low, the rate of increase in money wage rates is high.

This is because, “when the demand for labour is high and there are very few unemployed we should expect employers to bid wage rates up quite rapidly.”

The second factor which influences this inverse relationship between money wage rate and unemployment is the nature of business activity. In a period of rising business activity when unemployment falls with increasing demand for labour, the employers will bid up wages.

Conversely in a period of falling business activity when demand for labour is decreasing and unemployment is rising, employers will be reluctant to grant wage increases. Rather, they will reduce wages. But workers and unions will be reluctant to accept wage cuts during such periods. Consequently, employers are forced to dismiss workers, thereby leading to high rate of unemployment. Thus when the labour market is depressed, a small reduction in wages would lead to large increase in unemployment. Phillips concluded on the basis of the above arguments that the relation between rates of unemployment and a change of money wages would be highly non-linear when shown on a diagram. Such a curve is called the Phillips curve.

The PC curve in Figure is the Phillips curve which relates percentage change in money wage rate (W) on the vertical axis with the rate of unemployment (U) on the horizontal axis. The curve is convex to the origin which shows that the percentage change in money wages rises with decrease in the employment rate. In the figure, when the money wage rate is 2 per cent, the unemployment rate is 3 per cent. But when the wage rate is high at 4 per cent, the unemployment rate is low at 2 per cent. Thus there is a trade-off between the rate of change in money wage and the rate of unemployment. This means that when the wage rate is high the unemployment rate is low and vice versa.

The original Phillips curve was an observed statistical relation which was explained theoretically by Lipsey as resulting from the behaviour of labour market in disequilibrium through excess demand.

Several economists have extended the Phillips curve analysis to the tradeoff between the rate of unemployment and the rate of change in the level of prices or inflation rate by assuming that prices would change whenever wages rose more rapidly than labour productivity. If the rate of increase in money wage rates is higher than the growth rate of labour productivity, prices will rise and vice versa. But prices do not rise if labour productivity increases at the same rate as money wage rates rise.

This trade-off between the inflation rate and unemployment rate is explained in Figure where the inflation rate is taken along with the rate of change in money wages . Suppose labour productivity rises by 2 per cent per year and if money wages also increase by 2 per cent, the price level would remain constant. Thus point B on the PC curve corresponding to percentage change in money wages (M) and unemployment rate of 3 per cent (N) equals zero (O) per cent inflation rate on the vertical axis. Now assume that the economy is operating at point B. If now, aggregate demand is increased, this lowers the unemployment rate to OT (2%) and raises the wage rate to OS (4%) per year. If labour productivity continues to grow at 2 per cent per annum, the price level will also rise at the rate of 2 per cent per annum at OS in the figure. The economy operates at point C. With the movement of the economy from B to C, unemployment falls to T (2%). If points B and C are connected, they trace out a Phillips curve PC.

Thus a money wage rate increase which is in excess of labour productivity leads to inflation. To keep wage increase to the level of labour productivity (OM) in order to avoid inflation. ON rate of unemployment will have to be tolerated. The shape of the PC curve further suggests that when the unemployment rate is less than 5 per cent (that is, to the left of point A), the demand for labour is more than the supply and this tends to increase money wage rates. On the other hand, when the unemployment rate is more than 5½ per cent (to the right of point A), the supply of labour is more than the demand which tends to lower wage rates. The implication is that the wage rates will be stable at the unemployment rate OA which is equal to 5½ percent per annum.

It is to be noted that PC is the “conventional” or original downward sloping Phillips curve which shows a stable and inverse relation between the rate of unemployment and the rate of change in wages.

Friedman’s View : The Long-Run Phillips Curve

Economists have criticised and in certain cases modified the Phillips curve. They argue that the Phillips curve relates to the short run and it does not remain stable. It shifts with changes in expectations of inflation. In the long run, there is no trade-off between inflation and unemployment. These views have been expounded by Friedman and Phelps27 in what has come to be known as the “accelerationist” or the “adaptive expectations” hypothesis.

According to Friedman, there is no need to assume a stable downward sloping Phillips curve to explain the trade-off between inflation and unemployment. In fact, this relation is a short-run phenomenon. But there are certain variables which cause the Phillips curve to shift over time and the most important of them is the expected rate of inflation. So long as there is discrepancy between the expected rate and the actual rate of inflation, the downward sloping Phillips curve will be found. But when this discrepancy is removed over the long run, the Phillips curve becomes vertical.

In order to explain this, Friedman introduces the concept of the natural rate of unemployment. In represents the rate of unemployment at which the economy normally settles because of its structural imperfections. It is the unemployment rate below which the inflation rate increases, and above which the inflation rate decreases. At this rate, there is neither a tendency for the inflation rate to increase or decrease. Thus the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation. It is thus an equilibrium rate of unemployment toward which the economy moves in the long run. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment.

This natural or equilibrium unemployment rate is not fixed for all times. Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy. These may be minimum wage laws,inadequate employment information, deficiencies in manpower training, costs of labour mobility, and other market imperfections.But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctlyforecasts inflation and can adjustwages to the forecast.

Criticisms

The accelerationist hypothesis of Friedman has been criticised on the following grounds :

1. The vertical long-run Phillips curve relates to steady rate of inflation. But this is not a correct view because the economy is always passing through a series of disequilibrium positions with little tendency to approach a steady state. In such a situation, expectations may be disappointed year after year.

2. Friedman does not give a new theory of how expectations are formed that would be free from theoretical and statistical bias. This makes his position unclear.

3. The vertical long-run Phillips curve implies that all expectations are satisfied and that people correctly anticipate the future inflation rates.Critics point out that people do not anticipate inflation rates correctly, particularly when some prices are almost certain to rise faster than others. There are bound to be disequilibria between supply and demand caused by uncertainty about the future and that is bound to increase the rate of unemployment. Far from curing unemployment, a dose of inflation is likely to make it worse.

4. In one of his writings Friedman himself accepts the possibility that the long-run Phillips curve might not just be vertical, but could be positively sloped with increasing doses of inflation leading to increasing unemployment.

5. Some economists have argued that wage rates have not increased at a high rate of unemployment.

6. It is believed that workers have a money illusion. They are more concerned with the increase in their money wage rates than real wage rates.

7. Some economists regard the natural rate of unemployment as a mere abstraction because Friedman has not tried to define it in concrete terms.

8. Saul Hyman has estimated that the long-run Phillips curve is not vertical but is negatively sloped. According to Hyman, the unemployment rate can be permanently reduced if we are prepared to accept an increase in inflation rate.

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