Non-accelerating inflation rate of unemployment, Managerial Economics


During 1970s economists encountered a puzzle  in  the sense that  inflation and unemployment  data  did not  fit  into the Phillips  curve for  many  developed economies. In  fact many  countries witnessed 'stagflation'  -  a combination of stagnation (a situation of high unemployment) and high inflation. The instability in  the Phillips curve prompted economists to look  into the possible reason of high inflation in spite of high unemployment in the economy. 

A limitation of  the  Phillips  curve  is  that both workers  and  employers  take decisions on the basis of real wage, not nominal wage. As we mentioned earlier when we enter into a contract on a hture date we incorporate expected inflation into it. Milton Friedman and Edmund Pheips suggested that  since real wage  is what matters, the change  in  nominal wage has  to  be  corrected by  inflationary expectations. In  the short-run the Phillips curve is stable but in  the  long run it shifts from  one  level  to  another, which makes  the long run.  Phillips curve  a  vertical-straight line. We  explain the process through which  shifts  in Phillips curve takes place in Fig.

1732_shift in philips curve.png

In order to explain the long run  Phillips curve (LRPC) we take an example  from Samuelson (2005). Let us assume an economy which is operating at the natural rate  of  unemployment  (u*). The  economy  is operating at  point A with  low inflation rate I1 as  in Fig.  13.4. People expect inflation rate to continue at I,  in the next period also. 

In the second period suppose the government follows an expansionary policy so that  unemployment  declines and  is  lower  than  u*. In  this  environment  firms compete  with each  other  to hire workers  as  a  result of which wage rate increases. With  little scope  for further expansion  in  output the  expansionary policy results in an increase in wage rate and prices so that the economy moves to point B on SRPCl in Fig. We  note  that inflation expectation has not changes so far and the economy is operating  on SRPCI. 

In  the  period 3 workers and employers perceive  that there  is  an  unexpected increase  in  inflation  rate.  Such  a  surprise prompts  them  to  revise  their inflationary expectations and  they  incorporate inflation at the  rate  I2 into their decisions. This results in an upward  shift in  the short run  Phillips curve from SRPCn  to SRPC2. Note that we have drawn SRPCz with  inflation rate 13 which is equal to 12. With inflation at the rate 4,  there is a decline  in demand for labour the unemployment rate starts increasing and the economy moves to point C in Fig.  The  outcome  of  the  above process  is  that the  economy ends up with  higher inflation rate although the rate of unemployment  remains the same. Real GDP of the economy remains unchanged while nominal GDP is higher. The  natural unemployment rate mentioned  above is called  non-accelerating inflation  rate  of  unemployment  (NAIRU). When  unemployment  is  equal  to NAIRU  there will  be  stability  in  the rate of inflation. When  unemployment departs from NAIRU, there is acceleration or deceleration in inflation  rate. Thus if  actual unemployment  is  less than  u*, inflation will  continue  to  accelerate- higher and higher in subsequent  years. The concept of NAIRU and expectations formation  explains the  hyperinflation witnessed  by  some  Latin American countries. Unless unemployment returns to its natural rate inflation spiral will keep on accelerating. The recessionary trend can also be explained by NAIRU. When  unemployment  is more  than  u*,  inflation will tend  to  fall  as  long  as unemployment is above u*.

Posted Date: 10/26/2012 6:18:44 AM | Location : United States

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