1. The Phillips Curve • The Phillips curve demonstrates the inverse relationship between rates of unemployment and the inflation rate

2. Unemployment and Inflation • The Phillips Curve is a relationship between unemployment and inflation identified by Professor A.W.Phillips. • The relationship was based on observations he made of unemployment and changes in wage levels between 1861 to 1957. • Phillips found evidence that was a trade-off between unemployment and inflation. The effect of this tradeoff was that efforts by governments to reduce unemployment were likely to result in increased inflation.

3. Phillips Curve Phillips Curve Inflation% Unemployment The Phillips curve slopes from left to right, highlighting the trade-off policy makers face between controlling inflation or unemployment.

4. Stagflation This relationship, identified by Phillips, was seen as support for Keynesian policies. In the 1970’s the relationship between unemployment and inflation seemed to break down. The Oil crisis saw developed economies experienced low growth, and inflation and unemployment increasing at the same time.

5. Stagflation Economists had difficulty explaining the phenomenon of rising inflation and rising unemployment Source: Morning Star Example of Stagflation

6. Monetarists Milton Friedman, a monetarist economist developed a modified version of the original Phillips Curve. Friedman called his diagram the expectations- augmented Phillips Curve.

7. Friedman adapted the Phillips diagram to include the role of expectations in the Phillips Curve. Friedman believed there were a series of different Phillips curves to illustrate each level of expected inflation. Friedman argued that if people expected inflation to occur then react (anticipate) and demand a higher wage rise. Individuals expectation of inflation would result in the diagram below.

8. Long-run Phillips curve SRPC1 SRPC 9 5 Inflationrate Unemployment rate A B

9. Monetarist view of the Phillips curve Friedman argued that in the long run the Phillip curve is vertical. The vertical long run Phillips curve is located at the natural rate of unemployment. The diagram shows that workers believe that the inflation rate is likely to be 5%. Excess demand may push inflation higher, causing the actual inflation rate to be 9%. Workers expectations of the inflation rate will influence their pay demands.

10. Expectations augmented Phillips curve At 9% inflation, workers are relatively cheaper. Firms will demand more workers. Demand for labour will crate upward pressure on wages. Unemployment will reduce from A to B. Workers will eventually recognise that the inflation rate is 9% and will raise their pay demands, causing prices and wages to converge

11. Expectations augmented Phillips curve Inflation at the natural rate of unemployment is zero. At this rate workers may believe that the current rate of inflation will continue in the immediate future. Government may choose to intervene in order to lower unemployment below the natural rate of unemployment. This action may increase aggregate demand through expansionary policies.

12. The short-term consequence of government policies would be a fall in the rate of unemployment and an increase in the rate of inflation. Workers seeing their real incomes fall with inflation would reduce their supply of labour and their would be a return to the natural rate of unemployment.

13. Opportunity cost The Phillips curve illustrates the trade-off between unemployment and inflation leads to …. leads to …. Inflation Inflation Unemployment Unemploymen