The relationship between unemployment and inflation, whilst not always predictable, tells us much about the performance of any given economy.

a) Using the appropriate model, show how economists seek to understand and explain the relationship between unemployment, inflation and expectations.
The economists use the Phillips curve to identify the relationship between unemployment and inflation. It is an inverse relationship therefore there is a trade off between the two factors: the price for lower unemployment is higher inflation rate. However, during the 1970s in the UK the phenomenon of the Phillips curve was broken. In the 1980s Thatcher’s government concluded that in order for the economy to grow the inflation needed to be combated first and the unemployment could then be reduced.

The Phillips curve was discovered by A.W. Phillips. He observed the relationship between unemployment and changes in wage levels from 1861 to 1957. His main discovery was that each time the government tried to reduce unemployment the inflation rate increased in the economy. Keynesians adopted this view and used it to justify their policies. However, in 1970 the UK suffered from stagflation, where there was high unemployment rate and inflation was rising.

The main properties of the Phillips curve are that the government was faced only with two possibilities, either to accept high unemployment or high inflation. Alternatively the government has to settle for a balance between the unemployment levels and the inflation rate.

Figure 1

However, when the stagflation hit in 1970s and persisted for a number of years, a lot of economists were straggling to explain this phenomenon and the most convincing explanation came from Milton Friedman who brought the expectations-augmented Phillips curve. He included ” expectations ” into the Phillips curve. Friedman argued that there was not one Phillips Curve, but many each representing an expected level of inflation. If the population in the economy expected a rising inflation, they would demand higher wages to correspond with higher ” expected ” inflation rate. Therefore the following situation occurred:

Figure 2

If the economy stat at U and the inflation rate is 0%, the government may decide to implement policies that will reduce unemployment in the economy. Therefore the policies are adopted that will lead to an increase in demand by 5%. The demand can be increased through targeting the aggregate demand. An increase in aggregate demand in the short run leads to a rise in national income and therefore the unemployment may fall, moving the economy from U to V. Shortages in the economy will increase prices. The consumers want to be compensated for the increase in the prices, as they would like their income to be ” real “. Therefore they will demand the wage rates to increase at the same pace as the inflation or higher. The wage increases may be provided, especially if therefore powerful trade unions involved and there is a lack of competition, which ultimately will lead to an increase in costs of business. An increase in costs shifts the aggregate supply curve to the left, moving from point V to W.

In order to maintain their profit margins the businesses will increase prices and shed labour (due to higher costs of wages) and therefore the economy would be brought back to the original unemployment levels (U) but with higher rate of inflation (5%). Therefore additional increase in demand for goods and services will lead to higher inflation, and any benefits of higher employment rates will be wiped out as there will not be any ” real ” increase in demand. On the diagram, the benefits of the shift from U to V will be wiped out by an increase in the number of labour being laid off, bringing the final point to W. As this cycle persists, labour gets ” wiser ” and starts expecting inflation.

The government may try to reduce the unemployment again, therefore producing another cycle: W to X to Y). The inflation rate will be higher then in the first round, as the consumers have an expectation of the inflation, therefore negotiating their business contracts not with 5% inflation increase but with 5% + n%. The expectations stem from the logic: if last year the inflation was 5%, then this year it can be 8%, therefore they need to negotiate 11% pay rise in order to see a real pay rise (covering for any anticipated inflation). Trying to reduce the level of unemployment below U would be inflationary. Therefore the point U is called the Natural Rate of Unemployment.

” Pragmatic economists continue to use the Phillips curve. However, unlike the static Phillips curve that was popular in the 1960s, the new curve can undergo sudden changes, so that following a set policy can have markedly different results at different times—the “trade-off” can worsen (as in the 1970s) or get better (as in the 1990s).

This can be seen in a cursory analysis of US inflation and unemployment data 1953-92. There is no single curve that will fit the data, but there are three rough aggregations—1955-71, 1974-84, and 1985-92—each of which shows a general, downwards slope, but at three very different levels with the shifts occurring abruptly. The data for 1953-54 and 1972-73 does not group easily and a more formal analysis posits up to five groups/curves over the period ” (Wikipedia, 2006)

b) Using the relevant data for the USA and Japan, apply the model discussed in (a) and interpret the performance of these two economies over the period 1970 to 2004. Consider whether the more recent data suggest the need for more vigorous government intervention in the running of the national economy.
The original Phillips curve was non-linear. The data, inflation rate and unemployment rate (% of work force) has been gathered to analyse the relationship between the two indicators from 1970 to 2004 for Japan and the US.

From fig 3 it can be observed that there is a clear Phillips curve occurring in Japan. As the unemployment rate went up over the years, the inflation decreased. However, in Japan the Phillips curve appears to be flattened:

Figure 3

There are three theories that explain this phenomenon. ” First, in Laxton, Meredith, Rose (1995), the size of the output gap determines the slope of the Phillips curve. In particular, the output inflation trade off becomes steeper as the output gap approaches the capacity constraint, which is the maximum possible level of output that firms can supply in the short run. As such, the short-run Phillips curve is convex, with a vertical asymptote at the capacity constraint. Second, in Ball, Mankiw, Romer (1988) as well as in Dotsey, King, Wolman (1999), trend inflation is among the determinants of the Phillips curve slope. In these models of costly price adjustment, the frequency of price adjustment depends on firms’ optimizing decisions. A decrease in trend inflation, for one, causes firms to adjust prices less frequently, which in turn implies a flatter Phillips curve. Third, in Lucas (1973), the slope of the Phillips curve depends on the volatility of aggregate demand and supply shocks. For instance, if aggregate volatility decreases, a larger fraction of any change in the overall price level is misperceived by firms as being a change in their relative price. In that scenario, any change in demand has a larger impact on firms’ production, and a smaller effect on inflation. That is to say, the Phillips curve flattens ” (Vierman, 2005).

Since the mid 1990s the linear relationship in the Japan was broken, when the inflation became negative. ” Finding out why deflation didn’t accelerate in Japan is our empirical tool to shed light on the nature of the output-inflation trade-off. We show that the absence of accelerating deflation in Japan cannot be adequately explained by popular explanations which assume a linear short-run Phillips curve with a time-invariant slope. On the contrary, we find that the three above-mentioned theories of non-linearity are consistent with the data. Moreover, each of the non-linear models outperforms an atheoretical benchmark model in which the Phillips curve is linear, but its slope is allowed to vary over time as a random walk. Among the theories of non-linearity, we find most evidence for the hypothesis that a decrease in trend inflation created an environment in which prices became gradually more sticky, which in turn caused the Japanese Phillips curve to flatten ” (Vierman, 2005).

While other countries fight the inflationary pressures, Japan is now fighting deflation. Deflation that is persistent and growing causes two main problems: non-performing loan problem and increasing national debt. ” National debt has been increasing rapidly. Due to the declining tax revenue and the successive budgetary stimulus packages, the debt-GDP ratio had reached 157 percent by the end of 2003. With extremely large budget deficit and declining nominal GDP, this ratio was incasing by 8 to 9 points a year. Even though the net debt-GDP ratio is still at 66 percent, it is likely to surpass 100 percent by 2008. The Japanese economy was in a very serious situation in early 2003. In spite of the zero-interest rate policy by the Bank of Japan, the GDP deflator was falling more than 2 percent par annum. The budget deficit was more than 8 percent of GDP and fiscal consolidation was almost impossible under zero or negative nominal growth. Nikkei 225 stock price index had fallen to only one fifth of its peak in 1989. The capital of major banks and life-insurance companies was running out very quickly due to the increasing non-performing loans and falling stock prices. Since short-term interest rates were already zero, conventional monetary policy tools had lost effectiveness. Usually a potent monetary policy weapon, an open market purchase of short-term government papers by the Bank of Japan (BOJ) was no-longer effective because zero-interest base money and zero-interest short-term government papers are now perfect substitutes. Long-term bond yields had fallen to extremely low levels. A further injection of base money was not likely to push down long-term rates further ” (Fukao, 2005).

Japanese economy has been growing very strongly since 2003 and Fukao (2005) thinks that there might be four potential reasons to explain this growth:

  1. The new governor of the Bank of Japan, Mr. Fukui, skilfully used ” announcement effects ” of monetary policy by showing that he is seriously fighting against deflation. While we could not expect much from the individual policy actions taken by the Bank, Mr. Fukui succeeded to improve the expectations of the Japanese business community.
  2. The rescue of failing Resona Bank in the spring of 2003 changed the perceived risk profile of shares of major Japanese banks. When the government nationalized Long-Term Credit Bank of Japan and Nippon Credit Bank in 1998, the shareholders’ equity was wiped out. On the other hand, the government saved the shareholders of Resona Bank with public money when it injected capital to the bank. This rescue operation changed the risk of bank stocks and started a ” moral hazard rally ” in the market.
  3. The very rapid expansion of Chinese economy induced an export boom for Japanese manufacturing companies. The Japanese export to China grew about 30 percent in 2003.
  4. The massive official interventions in the foreign exchange market kept the yen relatively weak. The government bought JPY 32.6 trillion of US dollars (about US$ 300 billion) in fiscal 2003 that ended March 2004. This is more than 6 percent of Japanese GDP and about twice the value of Japanese current account surplus in the same year ” (Fukao, 2005).

From Fig 4 it can be seen that the Phillip curve does not persist, or even exist in the US:

Figure 4

Source: US Bureau of Labour statistics 2005

In 1990-1992 the US went through a recession and it looked like the economy followed a certain Phillips curve. In the late 1980s the unemployment rate was very low – 5.3% and the inflation increased to 4.1% (average of 1984-1987 was 2.4%). Alan Greenstrong reacted by pushing up the interest rates. Tighter monetary policy as well as expectation shock (from the international policies choices that were done during that time) resulted in a sharp fall in aggregate demand. Unemployment rose to 7.6% in 1992 while the inflation fell. During the 1990s Clinton’s government was awaiting an increase in the inflation rate. By 1994 the unemployment dropped to 6.1% therefore inflation should have risen. The unemployment fell further by 1996 by the inflation did not show any negative correlation. The inflation did not rise even by 1999, when the unemployment went below the expected natural rate of unemployment. ” Where was the Phillips Curve? Until the end of 1997 there was confidence that the Phillips Curve would soon return. Temporary special factors–health care costs, rapid falls in computer prices, and so on–were momentarily retarding the tendency of inflation to rise when unemployment was lower than its natural rate. Such factors couldn’t last forever, could they? Of course not. So when their influence came to an end, inflation would begin its rise. But years passed, and inflation did not rise ” (DeLong, 2000).

The economists experimented with a number of theories of what could have led to a ” non-existence ” of the Phillips curve in the US. The idea that the natural rate of employment was estimated incorrectly or even that it has fallen over the years was speculated. Jim Medoff, in the 1990s, argued that technological and organizational changes led to labour being more productive and also that more people were doing the ” right ” jobs, therefore lowering the natural rate of unemployment. ” Others pointed to faster productivity growth that allowed higher wage increases to be consistent with relative price stability. Still others pointed to workers’ fears for their jobs generated by the memory of the deep recession and high unemployment of 1981-1983 ” (DeLong, 2000).

Figure 4

Source: US Bureau of Labour statistics 2005

“Perhaps the surprising thing is that the complicated economic processes determining changes in inflation could be summarized for so long by such a simple relationship as the standard Phillips Curve. In any event one thing is very clear: the simple theory of the relation between inflation and unemployment that economists have peddled for a quarter century no longer works; if economists are to be of any use, they need to come up with a better – and in all likelihood more sophisticated – approach to understanding why inflation rises” (DeLong, 2000).

Figure 5

Source: US Bureau of Labour statistics 2005

Bank of Biz/Ed (2006) ” Phillips curve – is unemployment inflated? ” [Available from]: (Accessed on: 17/03/06)

Economagic (2006) ” US unemployment rate ” [Available from]: on: 17/03/06)

Bized (2006) ” Unemployment Worksheet – The Phillips Curve – Trading off unemployment and inflation ” [Available from]: on: 17/03/06)

Hamada K, Kurosaka Y (1986) ” Trends in Unemployment, wages and productivity: the case of Japan ” Economica, 53, S275-S296 [Available from]:[email protected]/01cce4403066510a1c180a25&dpi=3&config=jstor(Accessed on: 17/03/06)

Vierman E (2005) ” Which non-linearity in the Phillips curve ” [Available from]: on: 17/03/06)

Wikipedia (2006) ” Phillips curve ” [Availablefrom]: on: 17/03/06)

DeLong J (2000) ” What happened to the Phillips Curve? ” [Available from]: on: 17/03/06)

Mitsuhiro Fukao (2005) ” Financial Strains and the Zero Lower Bound: The Japanese Experience ” [Available from]: on: 17/03/06)

Statistics Bureau and Statistical Research and training institute (2006) [Available from]: on: 17/03/06)

The Japan institute for Labour policy and training (2006) [Available from]: on: 17/03/06)

GPEC Information Centre (2006) [Available from]: (Accessed on: 17/03/06)


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