This paper intends to discuss the trade-off between inflation and unemployment with the help of Phillips curve. The trade-off has been discussed from the perspective of both short-run and long-run. Furthermore, the paper has focused on the differences between adaptive expectation and rational expectation. Significance of credibility in the economic policy has also been described in this paper.
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.
Trade of between Inflation and Unemployment in Short Run
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.
Phillips curve in Long Run
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).