According to this study, the trade-off between the inflation and unemployment can be explained with the help of Phillips curve which implies that the policy makers can target low unemployment rates or low inflation rates but not both simultaneously (Algan, Challe and Ragot, 2011). The Phillips curve shows that there is an inverse relationship between inflation and unemployment in case of short run, whereas, Phillips curve is vertical in long run. As per the demand side explanation, the Phillips curve is explained with the help of fluctuations in the aggregate demand curve (Ruprah and Luengas, 2011). In case the aggregate demand is high, there is high inflation rate and unemployment rate is low due to the increase in demand for goods and services in the UK market (Ruprah and Luengas, 2011). The rise in demand for goods and services raises the production as well as the employment level in the economy. In terms of the supply side economy, low unemployment leads to tight labour market conditions in the UK market that demanded high wages as well as price inflation (Ruprah and Luengas, 2011). The research aims at investigating the trade off between inflation and unemployment. It also provides a scope to the researcher to understand the importance of Phillips curve in explaining the trade off.
According to the Keynesian economists, in the short run, the Phillips curve is convex to the origin and when the economy moves from point A to B there is rise in inflation rate which is a result of the rise in prices within the economy (Ruprah and Luengas, 2011). This implies that there is low unemployment within the economy that is more workers are employed within the economy. However, there is a possibility that the real wages are falling as the economy moves from point A to B, but this was only possible in the short run. The short run aggregate supply curve indicates that the GDP within the economy rises with the rise price level in the UK market. As most of the people are employed within the economy, they start producing the goods which leads to rise in the GDP of the economy (Karanassou, Sala and Snower, 2005). With rise in GDP, there is rise in level of goods and services produced in the economy.
Figure 1: Graph depicting shape of Phillips Curve in SR
(Source: Sloman, Smith and Sutcliff, 2005)
According to the study, in the long run, there is no relationship between the inflation rate and the unemployment rate within the economy. This implies that graphically, the Phillips curve is vertical in shape and the unemployment is at its natural rate. If the unemployment rate is changed it only moves the economy along the vertical Phillips curve (Dow and Montagnoli, 2007). The natural rate of unemployment within the economy is called the ‘Non-accelerating inflation rate of Unemployment’ (NAIRU). As per this theory, the expansionary monetary policy will lead to temporary fall in unemployment level within the economy (Karanassou, Sala and Snower, 2008). Nonetheless, if the employment is above natural rate, there is acceleration in the inflation rate but if the unemployment rate is equivalent to the natural rate, inflation remains stable.
Figure 2: Shape of Phillips Curve in LR
(Source: Sloman, Smith and Sutcliff, 2005)
Due to the rise in the nominal wages, the production cost incurred by the supplier rises which leads to fall in profit levels and fewer workers are employed in the economy. As a result of the attempt to decrease the unemployment level in the short run leads to a high inflation and unchanged unemployment level in the long run (Castle and Hendry, 2009). There occurred a situation of stagflation when there were high rates of inflation and unemployment in the economy. For instance, in the diagram, if the economy starts at A and follows an initial rate of inflation and unemployment, there would be a rise in the inflation rate as per the expansionary economic policies of inflation (Ruprah and Luengas, 2011). As per the short run Phillips curve, the economy moves to point B. With the rise in aggregate demand, there is a large number of workers hired by the firms that produces greater output and as a result, the unemployment decreases in the economy (Jayadev, 2008). The high inflation raises the expectation of the workers for future inflation and there occurs a shift in the Phillips curve from the unstable equilibrium point B to stable equilibrium point C. According to the study, the rate of inflation remains higher in C.
According to the adaptive expectations during each time period, the individual revises the expectation for the future price based on the error caused in the current expectation (Ruprah and Luengas, 2011). The theory suggests that the expectation for the new period is formed based on the sum of past expectation with the error and weighted sum of the coefficient of the revision for expectations within the economy (Schreiber and Wolters, 2007). For instance, if the value of the coefficient is one, the expected future prices are equivalent to the current prices. In such cases, the expectation is known as static (Ruprah and Luengas, 2011). As per the study, the expected future price is the average of the current price and its expected value in the future period. The equation for adaptive expectation is given as follows.