29. Inflation-unemployment theory: the Phillips curve and its development. Phillips curve and explanation of stagflation.
Kinked Phillips curve =a model showing the relationship between demand-pull inflation and disequilibrium unemployment. Dependence of price level: P=(a+b)*(1/u) where a,b are constant
T
wo
parts of curve: elastic and inelastic
1) inelastic: AD>AS, prices rise more rapidly than unemployment falls
2) AD=AS the point corresponds to natural rate of unemployment
3) elastic: AD<AS, unemployment will rise more rapidly than prices fall
Shift of Phillips curve depends on:
non-demand inflationary factors
changes in equilibrium unemployment
Development of the inflation unemployment theory:
1) Monetarists contribution. Basic hypothesis: adaptive expectations theory = people use their expectations of inflation on the previous year rates. Monetarists argued that there is a close correlation between the rate of growth of the money supply and the rate of inflation. Monetarists thus argued that the long-run Phillips curve is vertical.
2) New classical contribution. Rational expectations theory: people base expectations of inflation on the current information and personal evaluation of the government policies and promises. According to rational expectations theory the real and the only result of any government activity will be inflation.
3) Modern Keynesian contributions. Basic hypothesis: both adaptive and rational expectations take place but they concern not only price level tendencies, but also output and employment tendencies. Keynesians rejected the notion of a totally vertical Phillips curve, but did accept that demand-side policies alone cannot cure unemployment completely.
Stagflation = term used in the 1970s to refer to the combination of stagnation (low growth and high unemployment) and high inflation.
The possible ways to overcome stagflation (allow Phillip’s curve to go back)
1) price and income policies (cutting prices and wages at the same time)
2) improvement of information on the labor market in order to diminish equilibrium unemployment
3) pro-competition policy - antimonopoly and anti-unions
4) supply-side policy(policy to encourage AS)