Unemployment and Inflation – The Phillips Curve

At times of higher inflation, it is common for interest rates to lag behind, making real interest rates negative. The rate of interest does not fully compensate for the increased price level of goods due to inflation. If real interests rates are negative, then people with money in savings accounts will actually be losing money with the real value of savings falling. It was once the case that economists believed that inflation discouraged saving during high inflation, however, it is now believed that people save more during these periods to stop themselves losing money

High rates of interest also create uncertainty in the future. This uncertainty has negative effects both on political and social issues as well as economic factors. It is also true that this uncertainty has a negative effect on economic growth. In period of high inflation, businessmen will use speculative investment – when investors only invest for a capital gain that will be brought about through inflation. In these type of circumstances, these people are only investing out of personal gain or profit, they do not aid economic growth.

If the UK exchange rate is fixed, there will be a higher rate of domestic inflation, thereby leading to higher export prices, making exports less competitive of the foreign market. Import prices will then be relatively cheaper, making them more attractive and competitive in the domestic market. In these circumstances, the UKi?? s effort of payment would move into deficit. The costs that inflation imposes on society depends on whether the inflation is anticipated or unanticipated. Anticipated inflation imposes less cost than unanticipated inflation.

Anticipated inflation occurs where economic actors correctly predict future rates of inflation and therefore, modify their behaviour accordingly. Unanticipated inflation is highly volatile and so economic actors cannot predict its future rate. In 1958, the well known economist A. W. H. Phillips, discovered a relationship between unemployment and inflation – The Phillips curve. The relationship was first published in an article in the academic journal ‘Economicai??. Phillipsi?? research was focused on the economic statistics between 1861 and 1957.

He looked at the rate of change in ages, and the level of unemployment. He found a stable, inverse relationship between these two variables. A conventional Phillips curve is shown in the diagram below. (draw Phillips curve here) At point N on the diagram, the economy will be experiencing stable prices, at any point below N, the economy will experience inflation and any point below N, the economy will experience deflation. It is also true that if the level of unemployment, the greater the sensitivity of prices to a given change in unemployment.

The Phillips curve relied very heavily on one main assumption: that productivity in the economy is growing at around 2% p. a. The conclusions of the Phillips curve was that if unemployment was at around 2. 5%, the economy would enjoy stable prices and if unemployment was at around 5. 5%, then wage rates in the economy would stabilise. However, these figures are rooted in the economic performance of the 1950i?? s and 60i?? s. However, the important aspects of the Phillips curve are its Policy Implications. The government was offered a trade-off between unemployment and inflation.

The curve also suggests that it may be possible to lower unemployment without increasing inflation. This is done by shifting the curve to the left, thereby lowering the trade-off between lower unemployment and inflation. A leftward shift in the Phillips curve would be brought about by the adoption of a successful incomes policy. Both Labour and Conservative governments adopted these in the 60i?? s and 70i?? s. Essentially, they set non inflationary limits to wage increases which trade unions accepted by law. These policies were seen to work only in the short-term, never in the long term.

1980s Key Facts 1979 – 1982 RECESSION. UK enters recession before the rest of world. Tight fiscal ; monetary policy – interest rates at 17%, money supply targets 6- 10% and government expend. cuts of i?? 3. 5bn. announced for ’80-’81. “Winter of Discontent” – end of pay policy – 29m working days lost through strikes (largest annual total since general strike). Government pays large public sector pay increases as recommended by Clegg Commission. Introduction of Tax ; Price Index in Aug. ’79 and in Oct. ‘ 79 removal of exchange controls.