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Unit-23: Phillips Curve Analysis

is with the fact that labours may correctly forecast inflation to some extent and he may adapt wages Notes
according to the forecast.
Assume that economy is moving at a slow rate of inflation of 2% and natural rate of unemployment
(N) is 3%. In Figure 23.3 at point A of Phillips curve SPC , people expect the same rate of inflation to
1
remain in future. Now assume that government, for reducing the rate of unemployment from 3% to
2%, in order to increase total demand adopts monetary–fiscal programme. When actual inflation rate
(4%) is more than the expected inflation rate of 2% then economy moves from point A to point B on
SPC curve and unemployment rate temporarily falls till 2%. It happens because labourer has been
1
deceived. He had an expectation of inflation rate of 2% on which his wage demand was based. But
at the end labourers start understanding that actual inflation rate is 4% which now becomes their
expected rate of inflation. When once this happens, short term Phillips curve SPC shifts rightward
1
to SPC . Now labourers, because of the high rate of inflation of 4% demand for increase in money
2
wages. They demand for higher money wages because they understand that present money wages, in
real meaning are insufficient. In other words, they want to stay with high prices and want to do away
with fall in actual wages. Consequently, actual labour costs increase, firms will remove labourers and
along which change of curve SPC to curve SPC unemployment will rise from point B(2%) to point C
2
1
(3%). At point C, natural rate of unemployment re-establishes, which is the higher rate (4%) of both,
the actual and the expected inflation.
If government’s decision is to maintain unemployment level of 2% then it may do so only at cost of
high rate of inflation. At curve SPC , from Point C through increase in total demand unemployment
1
may once again be reduced up to 2%, until we do not reach point D. At point D, along with 6%
inflation and 2% unemployment, expected rate of inflation for labourers is 4%. As soon as they will
adjust their expectations to new situation of 6% inflation rate, short term Phillips curve again shifts
upwards towards SPC and unemployment will again
3
increase at its natural rate of 3% at point E.
If point A, C and E are joined , then at natural rate of
unemployment a vertical short-term Phillips curve LPC
is drawn. On the curve trade-off between unemployment
and inflation does not happen instead at points A, C and
E, from many rates of inflation, any one rate matches
with natural unemployment rate of 3%. Any other cut
in unemployment rate below its natural rate will bring a
fast rising and at the end an explosive inflation. But it is
possible only temporarily until labourers forecast inflation
rate to be less or more. In long term, economy will be
forced to establish on natural rate of unemployment.
That is why except for short term, trade-off between
unemployment and inflation does not happen. Its
reason is this that inflationary expectations are amended
according to what has happened in the past. That is why
when actual rate of inflation in figure 23.2 will increases Figure 23.2
till 4%then labourers for some time keep expecting 2% inflation and only in long term they amend
their expectation above 2% till 4%. Since they adapt their expectations, this is why it is also known as
“Adaptive expectations hypothesis”. According to this hypothesis expected rate of inflation always
remains behind actual rate of inflation. But if actual rate remains stable, then expected rate will in
the end be equal to it. Form it, this is inferred that there is short term trade-off between inflation and
unemployment but between both, long term trade-off does not happen unless a constantly rising
inflation is not tolerated.

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