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Unit 11: Control of Inflation and Philips Curve

which would previously yield, say 4% inflation and 3½% unemployment, may now result in 4% Notes
inflation and 5½% unemployment. The PC may also shift to the right due to changes in the
inflationary expectations. If workers and management expect considerable price escalation, in
the future, these expectations will be included in the former’s wage demands and the latter’s
price policies. If so, the PC may shift to a less desirable position.
The main inference of the recent studies which have attempted to test the PC is that the inflation-
unemployment relationship cannot be as clearly defined as the original PC did. The reason for
this is that the modern economic system is not as easy to manage or describe as it once was. The
simple and straightforward formula of the PC no longer holds with accuracy. Nevertheless, PC
does highlight the dilemma faced by policy makers in pursuing an anti-inflationary policy
which can also result in a fall in output and employment. In times of cost push inflation, full
employment at real income level becomes maintainable only at rising price levels. Thus,
maintaining price stability is often at the cost of real output.

!
Caution PC has little relevance to the Indian economy. Here unemployment is chronic and
is largely the result of high population growth. Little dent has been made on the level of
unemployment despite moderate to high rates of inflation since the second five year plan
period. As a result, we have both – a high rate of inflation and high rate of unemployment.

Thus, the long run Phillips curve is vertical at the natural rate of unemployment. Because
expectations of inflation lag behind actual inflation, there exists a temporary trade-off between
inflation and unemployment. But the trade-off is an illusion and as soon as expectations catch
up with actual inflation, the economy will return to the natural rate of unemployment
(Figure 11.3).
Figure 11.3

11.3.2 Stagflation

The combination of high and accelerating inflation and high employment is known as stagflation.
When the government utilises expansionary monetary or fiscal policy in an attempt to lower
unemployment below the natural rate, expectations of inflation exceed actual inflation and the
short run Phillips curve shifts upward. Inflation continually increases until government gives
up its attempt to do the impossible.

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