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Unit 11: Control of Inflation and Philips Curve

inflation can be eliminated if the community is prepared to accept a high rate of unemployment Notes
or vice versa.

Example: Point A on the PC shows low unemployment rate but the society has to pay a
price n terms of high inflation rate. Point B shows the contrary in that a low rate of inflation calls
for a high rate of unemployment.
It can be seen that the PC gets steeper at low rates of unemployment. Since wages form a large
fraction of the costs of goods and services, high wage increases tend to be associated with high
inflation rates. So the PC is usually thought of as relating price inflation to unemployment.

!

Caution The convex shape of the PC (from the point of origin) has an interesting implication.
Its flatness at high rates of unemployment and steepness at low rates suggests that reducing
unemployment from, say 10% to 9%, would not cost much in extra wage inflation, but
reducing unemployment from, say 2% to 1%, would cause substantial wage inflation.

The trade-off between inflation and unemployment suggested by the PC has drawn considerable
attention in the Macro Economic policy analyses since the 1960s. It seemed quite consistent with
the Keynesian inflationary gap analysis developed in the 1930s-1950s. The inverse relation
between wages and unemployment is attributable to two factors.
First, the relative bargaining strength of trade unions and management is likely to vary with
changes in the unemployment rates and general business activity. When unemployment rates
are low and there arise labour shortages, the trade unions tend to press for substantial increases
in money wages. During the periods of high unemployment, on the contrary, the wage claims
are generally not pressed upon the managements.
The second factor explaining the inverse relation between money wage rate and unemployment
rate is a state of generalised excess demand for labour. It is not necessary that wage increases are
brought about by the organised union action. Even in developed countries, only a fraction of the
total labour is unionised, yet money wages may rise both in the unionised and non-unionised
segments of the labour market primarily due to an excess demand for labour. The Phillips type
relationship between money wage rates and unemployment rates may also exist due to excess
demand in particular labour markets. If there are difficulties in the occupational and geographical
mobility of labour, the existence of labour shortages in particular sectors may push the wage
rates even in a period of unemployment.

11.3.1 An Evaluation of Philips Curve

The PC has come in for considerable criticism. Recent empirical evidence as well as the remarked
results on Phillip’s data have questioned validity of the negative wage rate-unemployment rate
relation.

Did u know? RG Lipsey who re-worked on Phillip’s data covering the period 1862 -1957,
has shown that over 4/5th of the variation of money wages could be associated with the
rate of unemployment. But he also points out that the relation between wage rates and
unemployment rates was much weaker during the period after 1913. Lipsey found that the
wage changes were related significantly to the changes in the cost of living index during
the inter-war and post-war periods.

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