Economics Assignment Writing Question: Philips Curve Analysis

The following papers outline the development of the so-called Phillips curve. Write a short paper of no more than 2,000 words describing and discussing the following:-

1) Interpretation of the Phillips curve in the early 1960s.
2) Criticisms of this approach by Friedman and alternative interpretation.
3) The use of rational expectations by Lucas and how this approach differed from Friedman’s. Use of international data used by Lucas.
4) The implications of rational expectations for the use of monetary policy and differences from Friedman’s position.

Introduction

            The following paper includes the discussion about the Phillips curve. The paper discusses about the interpretation of the Phillip curve in the period of early 1960’s. The paper also discusses about the criticism of the Phillip curve approach by Friedman and also the alternative interpretations. The rational expectation proposed by Lucas has also been described in the paper along with how approach of Lucas was different from that of the one proposed by Friedman. The paper also described the implication of the rational expectations for the use of the monetary policy and how this theory is different from the one position proposed by Friedman.

Interpretation of the Phillips curve in the early 1960s

            The interpretation related to the Philip curve usually starts from the findings of the negative or inverse relation ship in between the unemployment and inflation. In simple terms it can be said to be as the lower the level of employment in the country the higher will be the rate of inflation. As per A.W. Phillips who established the functional relationship in between the rate of growth of money wages and rate of unemployment. As per him the with the decrease in the level of unemployment, the money wages tends to rise and it remains stable only at a certain unemployment rate. By this explanation the neoclassical economists used this to explain the term inflation by the establishment in between the direct relationship in between the rise in the level of money with the rise in the general level of prices interpreting the more the level of employment the lower the level of real wages (Humphrey 1985).

Philip curve in the original and in the reformulated versions have mainly two uses. In the theoretical model related to inflation this curve provides a missing equation that exerts how the changes in the nominal level of income divide’s themselves into a quantity and price components, while related to the policy, it provides conditions that contributes to the effectiveness of the disinflationary and expansionary policies. This policy helps in predicting that the disinflationary policies will either perform slowly or swiftly which will depend on the price expectations or the speed of such adjustments (Gordon 2009).

The idea of trade-off in between the inflation and unemployment was hardly new. It has also been included in the key doctrines of the monetary by David Hume (1752) and H. Thornton (1802). The equation has been identified by the I. Fisher in the year 1926, though he viewed the causation as running from the inflationary measures to level of unemployment and vice versa. This was graphed using a scatter plot diagram chart by A.J. Brown in the year 1955and also presented a form of diagrammatic curve by P. Sultan in the year 1957. This was not still in the main usage until the publishing of the A.W. Phillips article in which the author fitted a statistical equation w=f (U) in the annual data available for the changes in the money wages (w) and the level of unemployment (U) in UK for the period of 1861-1913 (Schwarzer 2012).

This was represented by the usage of a chart in which the wage inflation was measured in vertical terms while the unemployment level was measured horizontally. This shows a smooth downward sloping graph in terms of a convex curve that is cutting the horizontal axis from centre at the positive employment level. This curve represented the response of the wages to the increase in the demand for labour and this increase in demand becoming the reason for the inverse of the unemployment rate. With the low unemployment level shows the high demand and has also shown the upward pressures on the wages. The greater the levels of this labour demand the higher and faster the increase in the wages rate. Similarly the high employment level provides for negative and excessive demand that puts deflationary pressures on the level of wages. Thus the increases in the excess demand for the labour will run into the diminishing marginal return for the reducing unemployment. This shows that the curve must be convex to the origin showing successive and uniform decrements in the level of unemployment and this will require progressively larger amount of increments due to the excessive demand in order to achieve them (Schwarzer 2012).

Criticisms of Phillips curve approach by Friedman and alternative interpretation

            As per Friedman based on the analysis of the Philip curve the workers are cheated constantly. As per him the higher money wages was just an illusion, because the higher level of inflation will really make the value of real wages fall. Friedman objected this fact and shows that in reality as per him the workers are more concerned of their real wages instead of the money wage rate they are offered and in this terms bargaining on the money wage rate is not taking inflation into account. As per Friedman he gave an alternative scenario which is as follows: as per him if it is assumed that the rate of inflation was initially zero at certain level of inflation and the government acts to increase the level of demand by using the monetary policy for reducing the level of unemployment (Laet 1994).

At this point and scenario the organizations can become ready to provide the workers with higher wages. Because at this level the workers are unable to analyze the inflation correctly and they assume that their real wage rate has been raised so at this point the supply of the labour force rises and the level of employment also increase. Eventually when the workers come to realize that actually their real wages has been decreased they tend to demand higher wages and this makes both the level of unemployment and prices increase. This process ends when the workers does not expect any inflation in the economy and does not demand for the higher wages. This shows that the zero rate of inflation can only be demanded at the point when there is an initial rate of unemployment (Schwarzer 2012).

Thus as per Friedman in the long run the even after the several attempts of the government the level of unemployment in the economy returns to this point which is said to be as the natural rate of unemployment. And at this point the economy experiences a higher rate of unemployment. As per Friedman and his analysis the government is not in the position to permanently affect the economic behaviour by the modifications in the level of unemployment. The government only has the powers to modify the level of unemployment for a temporary period and during this period the workers become knowledgeable to anticipate the level of inflation (Lucas and Sargent 1981).

The use of rational expectations by Lucas and how this approach differed from Friedman’s

            The Friedman model was based on the two assumptions of the continuously clearing the market and also the clearance of the imperfect information’s prevailing in the market. After this and the issue of the two influential articles by Lucas in the year 1972 and 73 the Friedman model was extended by the addition of the third component i.e. the rational expectations the workers and the organizations or firms utilize their own knowledge to analyze the implications of the rise or fall in the wages on the overall wages level. the rational expectations propounded by Lucas means that the erroneous expectations are not repeated, or the errors are not repeated iones it is committed (Lucas and Sargent 1981).

            Under the explanations given by Lucas he removed the distinction in between the firms and the workers and treated all as the economic agents and said them “yeoman farmers” who are faced with both individual shocks related to their own relative pricing and also the macro shocks that are caused by the fluctuations in the factors like the monetary level and others. As per him the economic agent’s uses expectations for assuming from the past history that how much the changes in the local prices will represent an eccentric shock and how much this represents an macro shock. Lucas also represented that when the local shock of prices have a high correlation with the macro shocks, the agents does not changes the level of production by analyzing that no relative prices has been occurred eventually. Lucas used this in order to explain that why the Phillips curves in a nation like Argentina with a very high volatility in the macro factors would be much steeper as compared to the other countries like United States who have certainly a very high volatility (Schwarzer 2012).

The implications of rational expectations for the use of monetary policy and differences from Friedman’s position

            The concept of the rational expectations that has been led by Lucas and also his followers has been done in order to do startling predictions. He has argued that the level of the anticipated monetary policy cannot change the real level of the gross domestic product (GDP) in a regular or a predictive manner or way. This soon came to be known as the policy ineffectiveness of the predictions and propositions. In correspondence with the Friedman the Lucas approach has implied that the movement of the output that are away from the natural level of the price and requires some price surprises so that central bank of the nation cannot alter the output level by carrying out a expected change in the monetary policy of the government just by creating a surprise (Snowdon and Vane 2005).

            The term rational expectations also have some vital implications for the definitions of the monetary policy and it also has the relationship with the fiscal policy. It is inconsistent to look at the factors associated with the government budget constraints because of the instability which may arise in the monetary policy. If the fiscal deficit were permanently financed by the bonds then the inconsistencies may arise. This is because the expectations were forward looking, and the models which believe this hypothesis have some principles to be solved into a indefinite future period in order to reach at a solution in the current period (Laet 1994).

            The approach proposed by Lucas was highly criticized. This was not due to the reason of his introduction of the rational expectations, but this was because of the twin assumptions that were proposed by Friedman i.e. the continuous market clearing and another is the clearing of the imperfect information. The deviation of the current and the actual level of prices from

that of the expected level of prices are the only allowable source of the movements in the business cycle in the real gross domestic product. Thus even after the widespread appeal for the Friedman-Phelps and Lucas approach, this has served to be as the inadequate theory for the business cycles (Schwarzer 2012).

Conclusion

From the above analysis of the Philip curve it can be said that the Philip has developed a model in which there is an inverse relationship in between the level of wages and the unemployment. While this was criticized by Friedman and proposed that this cannot exist in the real market condition. As per Friedman if Phillips curve seems to be true then the wages and the level of employment will move in opposite direction so, as per him the level of the real wages needs to be increased in order to decrease the level of inflation. With the increase in the level of the money wages the workers does not gets benefited due to the prevailing level of inflation. After this Lucas also added a third part in the Friedman explanations as rational expectations that means that errors cannot be repeated in long run.

MA67

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