Question

8. The Phillips curve is based on the observed negative relation between the rate of inflation and the unemployment rate. That is, decreases in the unemployment rate tend to be associated with increases in the rate of inflation a) Given what you know about the relation between the unemployment rate and the GDP gap, restate the Phillips curve in terms of inflation and the GDP gap. b) Based on the AD-IE model, and given your answer in (a), explain why the Phillips curve is not likely to be stable over time. Why is it that trying to lower the unemployment rate below its full-employment level results in higher inflation? Using the AD-IE model, explain how a condition of stagflation-rising infla- tion and a negative GDP gap-falsifies the underlying principle of the Phillips curve. c. Loeturing vou about the

Answer 1

Ans(1) The Philip curve is the negative relation between unemployment rate and inflation rate. Higher the inflation lower will be the unemployment rate and vice-versa. The reason is that , if there is demand of any good is high this will shift the demand curve to right as a result to meet the higher demand producer will employee more labor and will produce more. The income of the worker will increase as the demand of goods as well as the worker is high so overall price will rise, this will motivate the producer to supply more , so the inflation is high and unemployment is low. This relationship us used by policy maker in the economy to check the unemployment rate and GDP ratio or inflation in the economy. The higher the unemployment rate lower will be inflation rate and lower will be the GDP growth.

(b) However as explain in the above there is negative relation between unemployment rate and inflation, but in long run it is not stable it shows only short run effects. As critics by many economist in long run the Philip curve is vertical line not upward sloping showing that in long run there is no relationship between unemployment rate and inflation. But using this relationship in short run can put the economy in better situation. As we know that unemployment rate can be reduced only on cost of rising inflation, a slightly increase in inflation can help the economy to grow at faster rate then earlier but high rate of inflation can worst the condition in the economy then before, if policy maker try to reduce unemployment rate lower then full employment level this will cause only to rise in price but the unemployment rate will be higher as the demand of the product will reduce because of high inflationary pressure in the economy. And demand for the worker will also be get reduced. So in long run it is not stable to reduce unemployment rate below full employment level.

(c) Stagflation is the situation in the economy when the inflation is high in the economy as well as unemployment rate is also high the policy maker not able to decrease both. As a result the GDP gap will also increase only in short run, but in long run the Philip curve is vertical line and will not show any relationship between them. So the inflation rate will rise along with the unemployment rate and to cure this policy maker try to reduce inflation in cost of rising unemployment rate for short run so the economy can be stable in the long run.