macroeconomic presentation

7/27/2019 Macroeconomic Presentation

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PHILLIPS CURVE

The Phillips curve emerged from a pioneering study by the New Zealand born economist

Alban William Phillips, who in 1958 attempted to quantify the determinants of wage inflation. After

a careful study of more than a centurys worth of data on unemployment and money wages in theUnited Kingdom, Phillips found an inverse relationship between unemployment and the rate of

change in money wages. It is important to note that in the 1920s, an American economist Irving

Fisher noted this kind of Phillips curve relationship, so some believe that the Phillips curve should be

called as the Fishers curve.

Phillips curve shows that in periods of low unemployment, labour scarcity drives money

wage rates upward; and in times of high unemployment, labour surplus drives money wage rates

downward. Phillips showed that data from the year 1948 to 1957 match data from the years 1861 to

1913. Specifically, he fitted a curve based on 1861 to 1913 data to the observations in the 1948 to

1957 periods and found that the old curve fits the new data amazingly well.

Phillipss original work was subsequently extended to a study of the relationship between therates of unemployment and the rate of inflation. This new Phillips curve depicts the alternative

combinations of the two social evils: inflation and unemployment. The combination of high

unemployment with low inflation (or high inflation with low unemployment) appears to be logical.

At low rates of unemployment, labour markets become competitive and push up wage inflation.

Conversely, at high rates of unemployment, labour markets are loose, and wages tend to fall.

Figure 1 shows an illustrative Phillips curve. The curve suggests that there is a trade-off

between inflation and unemployment. In other words, less unemployment can always be attained by

incurring more inflation and that the inflation rate can always be reduced by incurring the costs of

more unemployment.

Y

Rateofinflation(percent)

Rate of unemployment (per cent)

12

2

4 10O

X

R

S

Pc

Figure 1: Phillips Curve


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In Figure 1, pointR shows that if policy makers in this hypothetical economy desire only a 4

per cent rate of unemployment, they must accept a 12 per cent rate of inflation. On the other hand, if

policy makers desire a low rate of inflation, such as 2 per cent, they must accept a relatively high

unemployment rate 10 per cent. A curve such as this would help policy makers decide what the

optimal point on the Phillips curve should be. The optimal point is subjective; it depends on the value

judgments of policy makers. According to Phillips, for the United Kingdom a rate of 5.5 per centunemployment was needed for wage stability and a rate of 2.5 per cent unemployment was needed to

hold prices stable. This would mean that wages would rise by the same percentage as the increase in

labour productivity estimated by Phillips to be around 2 per cent for the United Kingdom. According

to Samuelson and Solow, who have plotted a similar curve for the United States, unemployment rate

has to be 5.5 per cent for maintaining price stability, assuming a 2.5 per cent annual increase in

labour productivity. Obviously, Samuelson and Solows results are more distressing than those

obtained by Phillips. The policy implication of the Phillips curve was that inflation could be

eliminated only, if society was prepared to tolerate an unemployment rate well above full

employment. Inflation was the price of low unemployment.

STAGFLATION AND PHILLIPS CURVE

The present day inflation is quite different from the traditional inflation with which the world

had to struggle. The Phillips curve was sometimes described as a menu for choice between inflation

and unemployment. But the present day inflation is accompanied by increasing unemployment.

Stagflation is inflation accompanied by stagnation on the development front. Under it, high prices

and high unemployment go hand in hand. No country on the earth is free from its clutches. It is the

most difficult type of inflation. Keynesian remedies like budget surpluses, higher taxes have, not

only arrested inflation, but have aggravated the unemployment situation in various countries. Thus,

any step to ease the unemployment through increased capital investment adds to the inflationary fire,

while any policy adopted to deal with inflation through cut in public expenditure, will increase

unemployment. Every country stands between devil (inflation) and deep sea (unemployment).

In the 1970s many countries experienced both high levels of inflation and unemploym ent.

Theories based on the Phillips curve suggested that this could not happen, and the curve came under

concerted attack from a group of economists headed by Milton Friedman arguing that the

demonstrable failure of the relationship demanded a return to non-interventionist, free market

policies. The idea that there was a simple, predictable and persistent relationship between inflation

and unemployment was abandoned by most, if not, all, macroeconomists. Thus, the theory of the

simple and stable Phillips curve is indeed dead. But Samuelson believes that the central insight of

the Phillips curve approach with a trade off between unemployment and inflation in the short-run is a

fruitful way of viewing todays macroeconomy.

NAIRU AND RATIONAL EXPECTATIONS

Some economists have criticized the Phillips curve as stuff and non sense, and they in

certain cases modified the Phillips curve. They argue that the Phillips curve relates to the short-run

and it does not remain stable. It shifts whenever peoples expect ations of inflation change. In

particular, it shifts upward as inflation gathers momentum. If the managers of monetary and fiscal

policies aim for a low rate of unemployment, inflation will accelerate to higher and higher rates.

Hence, this is known as the accelerationist argument.

New theories, such as rational expectations and NAIRU (Non-Accelerating Inflation Rate ofUnemployment) arose to explain how stagflation could occur. The latter theory, also known as the


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natural rate unemployment distinguished between the short-run Phillips curve and the long-run

Phillips curve. The short-run Phillips curve looked like a normal Phillips curve, but shifted in the

long-run as expectations changed. In the long-run, only a simple rate of unemployment (NAIRU or

natural rate) was consistent with a stable inflation rate. The long-run Phillips curve was thus vertical,

so there was no trade off between inflation and unemployment. It may be recalled that Edmund

Phelps won the Nobel Prize in Economics, in 2006, for this NAIRU or Long-run Phillips curve.

In Figure 2, the long-run Phillips curve is a vertical line. The NAIRU theory says that when

unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run,

policy makers will face on inflation unemployment trade off marked by the initial short-run Phillips

curve in the Figure. Policy makers can therefore reduce the unemployment rate temporarily, moving

from point A to point B through an expansionary policy. However, according to the NAIRU,

exploiting this short-run trade off will raise inflation expectations, shifting the short-run curve

rightward to the New short-run Phillips curve, and moving the point of equilibrium from B to C.

Thus, reduction in unemployment below the natural rate will be temporary, and lead only to higher

inflation in the long-run.

Since the short-run curve shifts outward due to the attempt to reduce unemployment, the

expansionary policy ultimately worsens the exploitable trade off between unemployment and

inflation. That is, it results in more inflation at each short-run unemployment rate. The name NAIRU

arises because with actual unemployment below it, inflation accelerates, while with unemployment

above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating

nor decelerating. One practical use of this model was to provide an explanation for stagflation which

confounded the traditional Phillips curve.

Y

Inflatio

nRate

Unem lo ment Rate

X

New short-run Phillips curve

Initial short-run Phillips curveA

B C

Figure 2: Long-run Phillips Curve

NAIRU or LRP curve


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The rational expectations theory said that expectations of inflation were equal to what

actually happened, with some minor and temporary errors. This in turn suggested that the short-run

period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU,

for example, would immediately cause inflationary expectations to rise and this imply that the policy

would fail. Unemployment would never deviate from the NAIRU except due to random and

transitory mistakes in developing expectations about the future inflation rates. In this perspective,any deviation of the actual unemployment rate from the NAIRU was an illusion.


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Business Cycle

Business cycle also known as trade cycle is an inherent part of the capitalist economy. No

other problem in the capitalist countries has haunted more theoreticians, statesmen and the general

public than that of business cycle. It implies wave-like fluctuations in the level of economic activity,

particularly in national income, employment and output. It is mostly present in a capitalist economy.

DEFINITION

According to Keynes, A trade cycle is composed of periods of good trade characterized by

rising prices and low unemployment percentages, altering with periods of bad trade characterized by

falling prices and high unemploymentpercentages.

FEATURES OF CYCLICAL FLUCTUATIONS

All fluctuations in the economy are not cyclical. Cyclical fluctuations have the following

prominent features:

Wave-l ike movements

Cyclical fluctuations are wave-like movements and are recurrent in nature. A trade cycle is

characterized by alternation of expansion (prosperity) and contraction (depression) in economic

activity. They are repetitive and rhythmic. The cyclical fluctuations contain oscillating movements in

the form of waves from peak to trough and trough to peak.

Synchronic

The entire business of an economy acts like an organism. Any happening on the economicfront affects the entire economy, and through the mechanism of international trade, the entire world.

The Great Depression of 1929 is a classic example.

Cumulative

The process of expansion and contraction is of a cumulative and self-reinforcing nature. Each

upswing or downswing feeds on itself and generates further movements in the same direction, until

its direction is reversed by external forces.

Self-generati ng forces

A trade cycle contains self-generating forces, that is, it can terminate the period of prosperity

and start depression. Thus, there cannot be either an indefinite depression or an eternal prosperity.

Not identical

The periods of trade cycle are not identical although they recur with great regularity. Some

are mild while others are severe. In some, the upswing is longer than the downswing and in others, it

is just the reverse.

Not symmetri cal

The peak and trough in a trade cycle are not symmetrical. The movement from upward to

downward is more sudden and violent than that from downward to upward. The downturn is sharp

and steep. In statistical terms, it is relatively narrow at its peak and flatter at its trough.


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PHASES OF A BUSINESS CYCLE

Normally, a business cycle can be divided into four phases. They are shown in Figure 3. The

Phases are:

(i) Expansion or prosperity or the upswing;(ii) Recession or upper-turning point;(iii) Contraction or depression or downswing;(iv) Revival or recovery or lower turning point

These phases are recurrent and uniform in the case of different cycles. But no phase has

definite periodicity or time interval. Pigou has pointed out that Cycles may not be twins but they are

of the same family. Like families, they have common characteristics that are capable of description.

A business cycle starts from the trough or low point, passes through a recovery and prosperity

phase, rises to a peak, declines through a recession and depression phases and again reaches a trough.

This is given in the Figure 3 whereEis the equilibrium position.

RecoveryThe phase of depression does not continue for long. The forces that cause depression are self

defeating. During depression, the businessmen postpone replacement of their equipment and the

consumers defer their spending on the purchase of durable goods. When prices crash, they start

purchasing capital goods and so the level of output increase which increase the level of employment,

and hence, aggregate demand and the same force rejuvenate the economy. The process of recovery

once started takes the economy to the peak of prosperity and the cycle is completed repeating itself at

frequent intervals.

Prosperity

In this period, there is all round prosperity. Business outlook is extremely optimistic. The

economy operates at full capacity. The level of employment is high, volume of output is large; the

price level tends to be rising; interest rates tend to increase; speculative activities are at a high pitch;

O

EconomicActivity

Y

X

Time

Figure 3: Phases of business cycle

Recovery

Prosperity

Recovery

Prosperity

Peak

Peak

Depression

Recession

Equilibrium position


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investment spending is at a high level; total income of the country increases and credit expansion is

at its peak. In short, the economic activity is at its pinnacle and the idle resources or unemployed

workers are very few.

Recession

The prosperity finally culminates into recession. Prosperity has the seeds of self-destruction.Over optimism will turn into acute pessimism. The entrepreneurs soon realise that they have over

stepped. They started retreating back. First, the inefficient and inexperienced firms collapse, then

even the efficient firms also follows out; the whole economy suffers from fear, frustration and

hesitation.

The banks get panicky and begin to withdraw loans from business enterprises. More business

enterprises fail. Prices collapse and confidence is rudely shaken. Building construction slows down

and unemployment appears in basic, capital good industries. This initial unemployment then spreads

to other industries. Unemployment leads to fall in income, expenditure, prices and profits. The

recession has cumulative effect. Once recession starts, it goes on gathering momentum and finally,

assumes the shape of depression. In the words of M.W.Lee, A recession once started, tends to buildupon itself much as forest fire, once under way, tends to create its own draft and give internal

impetus to its destructive ability.

Depression

The period of recession is rather short because depression sweeps the economy very soon.

Recession merges into depression when there is a general decline in economic activity. There is

considerable reduction in the production of goods and services, employment, income, demand and

prices. The general decline in economic activity tends to a fall in bank deposits. Credit expansion

declines, because the business community is not willing to borrow. Bank rate falls considerably.

According to Prof. Eastey, This fall in active purchasing power is the fundamental background of

the fall in prices. The entire economic activity becomes slack. Thus, a depression is characterized

by mass unemployment and general fall in prices, profits, wages, interest rate, consumption,

expenditure, investment, bank deposits and loans; factories close down; and construction of all types

of capital goods, buildings, etc. come to a standstill. These forces are cumulative and self-reinforcing

and the economy is at the trough. A cycle is thus once again complete.

The behaviour of a business cycle is very difficult to determine because of the multitudinous

factors and circumstances that lie behind cyclical fluctuations. Some economists attribute cycles to

exogenous causes and others to endogenous causes. Likewise, we cannot say anything definite about

the duration and length of the various stages of the business cycle. It is possible that the depression

phase is a prolonged one to be followed by quick recovery. It is also possible that the depression is ashort one, but is followed by prolonged recovery.

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