Tuesday, June 5, 2007

Phillips Curve: Inflation and Unemployment in UK

The UK is experiencing both low inflation and low unemployment. to what extent do these data contradict with phillips curve analysis? (40)

  • In recent years unemployment in the UK has fallen from 3 million (1992) to under 1 million (2007)
  • Inflation has fallen from 10% in 1992 and has remained close to the governments' inflation target of 2% +/- 1.

The phillips curve suggests there is a trade off between unemployment and inflation. This is because an increase in AD can cause higher output, and therefore, lower unemployment. As the economy gets close to full employment, inflationary pressures rise.

see: phillips curve

The UK experience suggests that a fall in both unemployment and inflation suggest this trade off no longer occurs. This is because phillips curve analysis suggests a fall in inflation should lead to higher unemployment.

However, there are other reasons to explain the fall in inflation and unemployment. For example, arguably there has been a fall in structural unemployment; a fall in the natural rate of unemployment. For example, better education and training, more flexible labour markets and more difficult to get government benefits.

see: natural rate of unemployment

Structural (underlying inflation) may have fallen for various reasons such as: improved technology, lower price of raw materials, increased labour productivity, the effects of globalisation and greater efficiency.

Therefore, there may be still a trade off between inflation and unemployment; however, this trade off is much better. The phillips curve has just shifted to the left.

However, monetarists dispute this, they argue there is no trade off at all in the long run. They believe the Phillips curve is perfectly inelastic. Monetarists believe economic growth.

Monetarist view of Phillips Curve

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