PHILIPS CURVE

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Economics data analysis question The Phillips Curve

(a)(i) The Phillips curve is the line which shows that higher rates of unemployment are associated with lower rates of change of money wage rates and therefore inflation and vice versa. The main principle of a Phillips Curve is that it shows an inverse relationship between inflation and unemployment. An increase in inflation would by this theory result to a decrease in unemployment. This theory argues that you can't have both unemployment and inflation increasing/decreasing at the same time.

(ii) Inflation is caused by an increase in aggregate demand. Inflation is a general rise in prices. When more is demanded prices rise. When demand increases output increases as well. To produce this higher level of output more workers are needed and thus unemployment decreases.

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This diagram illustrates how the relationship between inflation and unemployment works. The cause of inflation, demand, increases from D1 to D causing the price level to increase from EP1 to EP and quantity supplied/demanded to increase from EQ1 to EQ. The rise in prices represents the increase in inflation. The increase in quantity supplied demonstrates the decrease in unemployment.

(iii) The data from the European Union does support the relationship made by the Phillips curve but the data from the United States doesn't.

First of all the graph of the European Union shows a dramatic rise of inflation in the years 167 to 175. From here on a line of best fit can be drawn to see that the relationship here actually does exist though there are inconsistencies of course. A high rate of inflation (14%) with a relatively low rate of unemployment (4%) in the year 175, and a low rate of inflation (%) with a relatively high rate of unemployment (1%) shows this trend. The sudden increase in inflation in 167 might have been caused by extreme circumstances such as large increases in the money supply thus an increase in demand.

On the other hand we have the United States which does not at all show a relationship between the inflation rate and the unemployment rate. There is no trend what so ever. All points lie not in any pattern and a line of best fit can't be drawn. However, this doesn't mean that there is no relationship. It could be very possible that the United States haven't counted their unemployed properly neither inflation. The United States could have simply mislead the world and the Americans to satisfy them. Typical circumstances where this might occur under are periods before elections. The president at power might want to impress the civilian by both decreasing inflation and unemployment so that hopefully he would be re-elected.

So the government may change unemployment statistics by altering the way they count unemployment or changing rules and regulations. To decrease unemployment figures for example they might take into account the black market and voluntary unemployment. By putting more weight on certain types of products inflation rates can be altered as well.

(b) (i) The non-accelerating inflation rate of unemployment is the natural rate of unemployment, the level of unemployment which can be sustained with a change in the inflation. Certainly there is evidence of this type of unemployment in the 180s and the 10s.

The following diagram illustrates the working of the natural rate of unemployment.

The fact that the economy keeps tending back towards the same level of unemployment is known as this natural rate of unemployment. When the economic situation is such that that it is not in equilibrium they will always be moving toward it (the long run Phillips curve which is vertical). As shown in both the United States and the European (more on this later) the unemployment is above its natural rate, aggregate demand is less than long run aggregate supply. Unemployment will force workers to accept wage cuts. Firms will then take on more labour, expanding output and lowering unemployment to its natural level. On the diagram this is demonstrated by the current situation to move from A to B and then back to C the natural rate of unemployment.

This concept might be the explanation for the United States not to show a proper Phillips curve. Clearly the natural inflation rate of unemployment in the United States is at 6% as most points plotted are along this line. The graph shows that every time that the figures were going away from this unemployment rate they returned to it in the end. An example of this is shown in the patterns during the 180s. In 180 the unemployment rate was around 6%. Then both inflation and unemployment increased shortly, then decreased dramatically and finally unemployment decreased while unemployment decreased. The unemployment ended near 6% again. A similar patter occurred in the 10s. The cause of these patterns might be the result of policies of the United States. Perhaps the US applied this theory starting from 180 as they were at a relatively high inflation rate.

In the European Union the similar pattern occurred however far less evident than in the United States as this pattern occurred only ones and you can therefore not estimate the natural rate of unemployment. However the a similar principle occurred.

(ii) Supply side policies are policies designed to increase the productive potential on the economy and shift the long run aggregate supply curve to the right. The type of unemployment that would be reduced would be that of cyclical as unemployment decreasing and increasing may be considered as booms and slumps. When unemployment changes this means that output is changing as well provided that there are not too large changes in technologies. Generally Supply Side policies improve other economical values such as decreasing inflation, increasing output, decreasing unemployment and improving the current account.

This diagram shows the main policy aim of supply side policies. Supply has to increase so that output increases from Q1 to Q and as a result the price decreases.

Another great advantage of supply side policies is that the competitiveness in the international market improves. As supply gets increased the prices of the products will be decreased and there will be more competition in the countries market. This will increase exports as well.

Certainly there are disadvantages of the Supply side policies as well which especially Keynesians stress as they are for government intervention in the market. Implementing Supply side policies might lead to increases in the inequality of income. As supply side policies are aimed at increasing supply this will often be of the cost for people who possess less wealth or are unemployed. To shift the supply curve to the right governments must motivate the unemployed to look for job and work so that they contribute towards the economy. Therefore they will reduce unemployment benefits. The disadvantage then is that inequality of income will be increased and the sick, unskilled will suffer from the policy. The power of trade unions would decrease under Supply Side policies. Generally it is just the less well off that will find their financial status decrease. It is often argued that supply side policies work only in the very long term. This is a significant disadvantage because its relevance will be decreased. It will not be a policy used to solve current problems but future problems. It is very hard to foresee economic changes and they will not be very secure of predictions. Firms will get a larger amount of profit but often this might be on the cost of the environment as well. Pollution will increase. Budget deficits are likely to be created because of the tax cuts and countries using this policy might be working themselves into problems in the future.

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