SHORT-RUN TRADE OFF BETWEEN
INFLATION
BETWEEN INFLATION AND
UNEMPLOYMENT
THE PHILLIPS CURVE
The PHILLIPS CURVE is an economic In this image, an economy can either
concept developed by A. W. Phillips experience 3% unemployment at the
stating that inflation and cost of 6% of inflation, or increase
unemployment have a stable and unemployment to 5% to bring down
inverse relationship. The theory the inflation levels to 2%.
claims that with economic growth
comes inflation, which in turn should An increase in AD has caused the
lead to more jobs and less economy to shift from point A to
unemployment. point B. Unemployment has fallen,
but a trade-off of higher inflation.
It was proposed in 1958 by
economist A. W. PHILLIPs. In his
If an economy experienced inflation, then
original paper, Phillips tracked wage
the Central Bank could raise interest
changes and unemployment changes
rates. Higher interest rates will reduce
in Great Britain from 1861 to 1957,
consumer spending and investment
and found that there was a stable,
leading to lower aggregate demand. This
inverse relationship between wages
fall in aggregate demand will lead to
and unemployment.
lower inflation.
However, the original concept has been
However, if there is a decline in Real GDP,
somewhat disproven empirically due to
firms will employ fewer workers leading to
the occurrence of STAGFLATION in the
a rise in unemployment.
1970s, when there were high levels of
both inflation and unemployment,
WHY IS THERE A TRADE-OFF
because it contradicted the idea of the
BETWEEN UNEMPLOYMENT AND
said curve.
INFLATION?
Inverse relationship between inflation and
Changes in aggregate demand
unemployment: unemployment =
translate as movements along the
inflation
Phillips curve. For instance, if the
economy experiences a rise in AD, it
The relationship, however, is not linear.
will cause increased output.
Graphically, the short-run Phillips curve
As the economy comes closer to full
traces an L-shape when the
employment, we also experience a
unemployment rate is on the x-axis and
rise in inflation.
the inflation rate is on the y-axis.
However, with the increase in real
GDP, firms take on more workers
leading to a decline in unemployment
(a fall in demand deficient curve would also be optimal.
unemployment) increase output and
Thus, with faster economic growth in raise prices.
Increase in money will The aggregate supply
the short-term, we experience higher increase production due curve is vertical which
inflation and lower unemployment. to a shift in the reflects economists'
aggregate supply. belief that changes in
aggregate demand only
temporarily change the
economy's total output.
More goods are An increase in money
produced because the will do nothing for
output is increased and output, but it will
more goods are bought increase prices.
because of the lower
AGGREGATE DEMAND AND price.
SUPPLY
CLASSICAL THEORY
ECONOMIC OUTPUT Classical economics focuses on the
In economics, output is the quantity growth in the wealth of nations and
of goods and services produced in a promotes policies that create national
given time period. The level of output expansion. During this time period,
is determined by both the aggregate theorists developed the theory of value or
supply and aggregate demand within price which allowed for further analysis of
an economy. National output is what markets and wealth. It analyzed and
makes a country rich, not large explained the price of goods and services
amounts of money. in addition to the exchange value.
Anything that causes labor, capital, CLASSICAL THEORY ASSUMPTIONS
or efficiency to go up or down results a) Self-regulating markets: classical
in fluctuations in economic output. theorists believed that free markets
regulate themselves when they are
FLUCTUATIONS IN OUPUT free of any intervention. Adam Smith
a) short run = output fluctuates with referred to the market's ability to
shifts in either aggregate supply or self-regulate as the "INVISIBLE
aggregate demand; HAND" because markets move
b) long run = only aggregate supply towards their natural equilibrium
affects output. without outside intervention.
b) Flexible prices: classical economics
SHORT RUN VS. LONG RUN assumes that prices are flexible for
FLUCTUATIONS goods and wages. They also assumed
that money only affects price and
SHORT RUN LONG RUN
wage levels.
Outward shift in the The aggregate supply c) Supply creates its own demand:
aggregate supply curve curve and aggregate
based on Say's Law, classical
would result in demand curve are only
increased output and affected by capital, theorists believed that supply creates
lower prices. labor, and technology. its own demand. Production will
Outward shift in the Everything in the generate an income enough to
aggregate demand economy is assumed to purchase all of the output produced.
Classical economics assumes that economists believed that aggregate
there will be a net saving or spending demand for goods and services not
of cash or financial instruments. meeting the supply was one of the
d) Equality of savings and most serious economic problems.
investment: classical theory Excessive saving, saving beyond
assumes that flexible interest rates investment, is a serious problem that
will always maintain equilibrium. encouraged recession and even
e) Calculating real GDP: classical depression.
theorists determined that the real Cutting wages will not cure a
GDP can be calculated without recession.
knowing the money supply or Overcoming an economic
inflation rate. depression requires economic
f) Real and Nominal Variables: stimulus, which could be achieved by
classical economists stated that real cutting interest rates and increasing
and nominal variables can be the level of government investment.
analyzed separately.
CAUSES OF UNEMPLOYMENT
1. Large number of technological
advances.
KEYNESIAN THEORY 2. Jobs have become increasingly
Keynesian economics states that in the specialized.
short-run, especially during recessions, 3. Companies prefer hiring a few
economic output is substantially people on board.
influenced by aggregate demand (the 4. People voluntarily choose to remain
total spending in the economy). According unemployed.
to the Keynesian theory, aggregate 5. A higher literacy rate among men
demand does not necessarily equal the and women.
productive capacity of the economy. 6. The issue of the immobility of the
Keynesian theorists believe that workforce.
aggregate demand is influenced by a
series of factors and responds EFFECTS OR CONSEQUENCES OF
unexpectedly. The shift in aggregate UNEMPLOYMENT
demand impacts production, 1. Affects the economy of a region
employment, and inflation in the very negatively.
economy. 2. Reduces the spending power of
both the employed as well as
CHARACTERISTIC BELIEFS: unemployed.
Unemployment is the result of 3. Makes the individual feel very
structural inadequacies within the depressed.
economic system. It is not a product 4. It is a cause of distress to the entire
of laziness as believed previously. familv.
During a recession, the economy 5. Increase in crime in the country.
may not return naturally to full
employment. CAUSES OF INFLATION
An active stabilization policy is 1. The Money Supply Inflation is
needed to reduce the amplitude of primarily caused by an increase in
the business cycle. Keynesian
the money supply that outpaces
economic growth.
2. The National Debt.
3. Demand-Pull Effect.
4. Cost-Push Effect.
5. Exchange Rate Inflation.
RISK OF PERSISTENTLY HIGH
INFLATION WEALTH EFFECT INTEREST RATE
1. Income redistribution. EFFECT
2. Falling real incomes. The wealth effect The interest rate
3. Negative real interest rates. holds that as the effect explains that
price level increases, as outputs rise, the
4. Cost of borrowing. the buying power of same purchases will
5. Risks of wage inflation. savings that people take more money or
6. Business competitiveness. have stored up in credit to accomplish.
7. Business uncertainty. bank accounts and
other assets will
diminish, eaten away
THE AGGREGATE DEMAND CURVE
to some extent by
Aggregate demand refers to the amount inflation.
of total spending on domestic goods and
services in an economy. It is what THE AGGREGATE SUPPLY CURVE
economists call total planned The horizontal axis of the diagram
expenditure. shows real GDP — that is, the level of
GDP adjusted for inflation. The
FOUR COMPONENTS OF DEMAND: vertical axis shows the price level.
1. Consumption The price level shown on the vertical
2. Demand axis represents prices for final goods
3. Government spending or outputs bought in the economy,
4. Net exports – exports minus not the price level for intermediate
imports goods and services that are inputs to
One of the factors that determine AD production.
is the price level. Aggregate supply is the total amount
of goods and services that firms are
C = consumption spending; I = willing to sell at a given price in an
investment spending; G = government economy.
spending; X = spending on exports; M = In a standard AS-AD model, the
imports Aggregate Demand = output is the x-axis and price (P) is
the y-axis. Aggregale supply and
C + I + G + (X - M) aggregate demand are graphed
together to determine equilibrium.
The equilibrium is the point where
supply and demand meet to
determine the output of a good or
service.
The aggregate supply curve describes
how suppliers will react to a higher price
level for final outputs of goods and
services while the prices of inputs like
labor and energy remain constant.
WHY DOES AGGREGATE DEMAND
CROSS POTENTIAL GDP LINE?
The economic intuition here is that if
prices for outputs were high enough,
producers would make fanatical
efforts to produce: all workers would
be on double-overtime, all machines
would run 24 hours a day, seven
days a week. Such hyper-intense
production would go beyond using
potential labor and physical capital
resources fully to using them in a
way that is not sustainable in the
long term. Thus, it is indeed possible
for production to sprint above
potential GDP, but only in the short
run.
In the short run, it is possible for
producers to supply less or longed,
Powever, producers are disted to
porte igh. in the potencial GDP.
For this reason, economists also refer
to the AS curve as the short run
aggregate supply curve, or SRAS
curve.
