Economics

The Philips curve was conceptualized by A. W. Philips, who studied economic trends of the UK between 1861 and 1957. The result of the study was a curve that attempted to explain the relationship between unemployment and inflation. Philips proposed an inverse relationship between the two, saying that in cases of high unemployment, the rates inflation were low and vice versa. The curves slope from left to right offered the policy makers a choice of either accepting inflation or unemployment. The concepts derived from the curve were successful for a while (1958-1970) in explaining the unemployment and inflation rates until the 1970s stagflation that hit the developed economies in the 1970s.

The happenings during this period completely defied the Philips curve because both inflation and unemployment rose simultaneously, leading to a modification of the Philips curve. On the original Philips curve, Milton Friedman designed what he called the expectations augmented Philips curve- the word expectations added to denote an element of peoples anticipation for certain economic conditions (Hoover, 2008). The result was a series of curves each representing different expectations. A representation of an expectations augmented curve is shown below.

Figure  SEQ Figure  ARABIC 1source Bank of Biz
Assume that the economy is at U, a point at which the expected rate of inflation is 0. If the government decides to boost the aggregate demand as a way of reducing unemployment, there will be a movement along the curve to the point V as the unemployment rates reduce. With the increase in demand, shortages will occur in the economy, leading to an increase in prices. Consequently, people will seek wage increases above inflation rates, something that if granted will lead to adjustments by the employers to compensate for lower profit margins. The firms may either decide to reduce number of employees or push up prices. The net result of these actions is that a shift will lead to the curve moving to point W. From point W the government may again try to increase demand, moving the curve to X. However, this time around wage negotiations will be done on the assumption that the inflation rates will go beyond the previous one of 5 to, say, 8. In the long run, the Philips curve will be represented by the blue vertical line.

The new classical theorists saw the old classical economists as relying too much on market dynamics of supply and demand to explain the functioning of a free economy. According to them, the old theorists saw the price and free economy system as being capable of sufficiently guiding the supply and demand in the market. They attributed unemployment to market imperfections such as government intervention or actions from the labour unions. The new classical model however, recognises individuals as the optimisers of the economic functions. They do so based on their proper matching of prices against the assets (whether education or physical assets) they have. Therefore, while firms maximise profits, people maximise utility. The new classical theorists are in agreement with yet another theory known as rational expectations theory. The theory relates personal expectations to economic models. Based on the theory, an economic model that creates an outcome that differs from that of the people is a poorly formulated model. If the inconsistency between the model and the peoples expectations is due to false expectations by the people then they should use it (the model) to correct their expectations.

For example, anytime the government feels that the economic growth is leading to a high inflation, it will take anti inflationary measures to reduce the rates.  An example of an anti-inflationary policy is a monetary measure introduced by the exchequer to increase bank lending rates. In so doing, banks are discouraged from lending, leading to a significant reduction of money in circulation. While these policies may be good in as far as reducing inflation is concerned, they come at a price because they may slow down economic activity and increase incidences of unemployment, although this may be in the short term. Such consequences are referred to as sacrifice ratios.

Sacrifice ratio being a cost related to anti-inflationary measures is a function the process of the approach taken to reduce the inflation. There are two disinflationary approaches the cold turkey approach and the gradualist approach. As the names suggest, the gradualist approach is a process that is slow and measured while the cold turkey approach is a near knee jerk reaction to inflation. Each of these methods yields a different sacrifice ratio.  (Ball, 1993) found that the gradualist approach yielded a higher sacrifice ratio when compared to the cold turkey approach. The two prominent elements that are sacrificed or affected by the economy in pursuit of lower inflation are output and unemployment. The anti inflationary measures serve to slow down the economy, which means that the overall output from various sectors has to suffer. According to the Philips curve, anti inflationary policies will lead to a drop in unemployment because the drop in inflation means that firms will pay less for labour and will therefore be in a position to hire more people. If anti inflationary measures are employed at point X for example, the resultant change will not be a shift, rather the change will move along the curve so that there is a trade-off between unemployment and inflation. There may be a transitional period through which unemployment rates may increase but this would be a largely short term affair. However, there will be a general fall in output because the aggregate demand will have been reduced by the policy, leading to an adjustment of capacities by firms to match the levels.