Significance of inflation expectations in the Monetarist Phillips Curve
This was not the case in 1970s when both inflation and unemployment rates hit by almost same margin proving wrong most of these theories such as neoclassicism. Perhaps one of the most issues that faced Keynesians back in 1950s was the falling money wages. The Keynesians believed that the Keynesians unemployment model equilibrium could be shut by assuming the stability of money wages. This situation could otherwise be driven back to full employment when there was an experienced falling money wages according to Pigou and Keynes effects. In appreciating the significance of inflations in the Phillips Curve, one had to justify that the holding of money wages was indeed rigid (Michael, 2001, p.54). In the process of justification, people had to appeal to money illusions, labor market imperfections and so forth. Before Alban W. Phillips, the thoughts of money illusions and labor market imperfections were all scattered. A simple curve that was infamously known as the Phillips Curve challenged the economists in the 1950s. This curve related empirically the unemployment and the money wage growth.
Some of the Neo-Keynesian theorists quickly realized that the Phillips Curve was what that was important in burying the misleading Keynesian model. Other theorists such as Paul Samuelson, Richard Lipsey and Robert Solow were quick in integrating the Phillips Curve into the structure of Neo-Keynesian theory. What is observed in the Phillips Curve is that there is a clear short-term inflation and unemployment. However, the original Phillips Curve has received some criticism from the monetarists as well s the economists. The nature of the trade-off has also changed for the economy as well as to others when considering data from the inflation and unemployment rate over the past years (Snowdown, Vane, 1997, p.21). There are two possibilities behind Phillips reasoning.
The two elements, unemployment and inflation were seen to be affected in an inverse relationship. Phillips plotted the curve using data from the inflation trend and the unemployment rate in the UK. There was a general assumption that the falling unemployment rates could be a possible cause of the rising inflation and that a fall in inflation could definitely be possible in an economy of rising levels of unemployment.
The relevance of this in an economy is that if the government wanted to reduce the level of unemployment, then it could increase the cumulative demand. However, this kind of approach might only increase the employment rate in a temporal way and in addition the approach might also lead to some form of inflationary implications in product markets and labor. The main feature to understanding this form of trade-off is to look at the possible effects of inflation and the product markets that arise from an increase in national employment, output and income. The significance of inflation expectations in the Phillips Curve is the labor market and other factors are well monitored. As the employment rate falls, there are possibilities that the labor shortages might occur when there is a short supply in skilled labor. The shortage in skilled labor supply will in return exert some extra pressure on the rise in wages (Drobny, 1999, p.19). Because wages occupy a larger portion of the total costs, the prices may increase as the firms pass on the costs on their customers.
It is also important to consider some of the factor markets which might arise due to the interplay between the inflation and employments rates and trends. The cost-push inflation can severely result from the rising demand for the commodities such as copper, oil and the manufactured goods such as concrete, glass and steel. In a booming economy, the demand for the raw materials as well as these components will greatly increase.
Product markets are other important aspects to consider when expecting any of the two possibilities of the effect of economy on the employment and the rates of inflation. The rising demand as well as the output exert a lot of pressure on the severely scarce resources and may result into the suppliers hiking the prices in order to widen the profit margins of their commodities (Handa, 2000, p.34). The risk of the rising prices is greater when the demand is seen to be outstripping the supply level often leading to the excessive demand being realized. This is termed as a positive gap of output.
The original Phillips Curve in the beginning received significantly fierce criticism especially from the monetarists. Example of these monetarists included the great American economists such as Milton Friedman. Although Friedman admitted that the short run Phillips Curve indeed existed, he pointed out that in the long run, the curve was vertical and there were no trade-offs between inflations and unemployment. Friedman argued that each of the short run Phillips Curve was constructed on the assumption of a certain expected inflation rate. This implies that if there was a slight increase in the rate of inflation that is caused by a large expansion in the monetary basis then this would in deed result into an upward shift in the short run constructs of the Phillips Curve. The monetarist point of order is that that attempts to augment AD in order to achieve a lower unemployment as well as a faster growth in the economy has a merely temporary consequence on the effects on jobs. Friedman observed that a government cannot achieve to completely drive away the unemployment level below the NAIRU (Woodford, 2008, p.11). If the government attempted to lower the unemployment levels, this would eventually result into a return to greater unemployment rates but with inflation expectations heightened along the process.
Friedman introduced the concept of adaptive expectations meaning that if people perceive and experience high levels of inflation in their lives, they become highly expectant over higher average inflation rates in the future. In addition, the people or the trade unions which represent the people may then integrate the varying prospects into their bargaining on their pay. It is important to note that wages always follow the prices and a burst of inflations in price can accentuate to higher pay claims as well as the rising costs of labor. There will also be higher process of both goods and services that people desire and want to buy.
From the expectations of inflation, the government may make attempts to mitigate the problem of unemployment far below the unemployment rate by increasing the accumulative demand in the long run will have to succeed. The effect will be to establish a higher rate of inflation together with the increase in the inflation expectations (Grubel, 1997, p.25). The monetarist school of thought believed that inflation is only best controlled by tight control of credit and money. It is expected that the credible policies that ensure the keeping on top of inflation can also experience beneficial effects of decreasing the inflation expectations that cause the downward shift in the Phillips Curve.
There are concerns raised on identifying the importance of inflation expectations. The possible results on the operations of the macroeconomic policy of the government are considered and a relationship is extrapolated into other forms of data understanding. The setting of the interest rates can greatly indicate the necessity of the Phillips Curve. Usually, a reduction in the NAIRU will always present some of the implications that are considered to set up short term rates by the Monetary Policy Committee.
Monetarists have always doubted the type of trade-off that exists between inflation and unemployment, considering instead in the steadiness of the private sector that be predisposed to function near full employment (Woodford, 2008, p.16). In the past, while the Phillips Curve that was to as providing alternatives have as explanation of inflation, but in reality, the anticipations-augmented Phillips Curve was declared the missing equation in the monetarist model.
The trade-off that exists between the affects of inflation and unemployment foreshadows how fast the economies can enable the economy to eminently grow and expand over a medium term. The information gained from the expectations is essential for the government to make decisions on the key fiscal policies. The government will know how much it needs to spend on key public services that require more attention such as road, healthcare and transport as well as transport.
Forecast growth may greatly impact the expected tax revenues which when combined with the government spending can significantly determine the position of the government in borrowing. The concept of budget deficit come in and it is very critical in determining the capability of borrowing from the international lenders.Implications for the Conduct of Economic Policy
The capacity for a short run trade off between the inflation and unemployment still continues to take effect and this affects the conduct of the economic policies of any state. These changes of policies are meant to be adjusted in order to contain the differences that are left after the change in the levels of employment and inflations. Particularly the inflation rise in a country can impact the conduct of economical policy which will as well affect the demand and supply of goods and services. The changes in the inflation expectations totally alter the position of the short run curve as observed in the Phillips Curve (Drobny, 1999, p.37). The fall in the expectation of inflation lead to a downward shift of the SRPC.
Some factors may show the improvement the trade-off and these improvements are the ones that affect the economic policy of states. However, there is not as ingle factor that may be sufficient enough to account for the changing of the trade-off but some of the reasons may be postulated to cause this shift. For instance, the flexibility of the labor market in the UK can be said to have increased in size while the reduction in the trade union has greatly reduced the power of collective bargaining among many workers. This shows how the conduct of economical policy is greatly impacted by the changes of inflation expectancy. Identified also are some benefits of immigration although it ca gain be perceived to be hard to quantity with a good degree of accuracy the extent to which this factor has impacted the economical policy and the issue of labor migration in general. In general, the rise in inward migration may be said to have helped relive the labor shortages in a number of sectors of the UK economy and thus helped control the upward pressures on the wage inflation. There are also effects of the credible targets of inflation that use the inflation targets to reduce the inflation expectations (Snowdown, Vane, p.50). The adoption of inflation targets in the UK has been a very critical step in establishing a sound monetary policy framework as a manner of embedding the low-inflation in the UK economy.
Another factor which might be important to examine is the technological change and inventions which have increasing raised the labor productivity at the same time cutting the cost in many different industries. This great fundamental change in the side of supply of the international and the British economy has been a major determinant in keeping the inflation at low levels even when the unemployment rates are soaring (Michael, 2001, p.93). In brief, the significance of inflation expectations is not overstated when the concept is given much weight to even bring the economy down. It is due to this reason the earlier economical researchers such as Phillip, Keynes and Friedman recognized its importance and came up with powerful theories that have both gained support and fierce criticism.