The Phillips CurveAnticipated Inflation: Occurs where individuals and groups correctly factor in expected changes in inflation into decision making e.g. wage negotiations, contract discussions, etc.Unanticipated Inflation:Where changes in inflation are not factored into decision making can lead to:Changes in distribution of income e.g.factoring in inflation above actual levels in wage negotiations may lead to a redistribution of income from employers to employeesEffects on Employment e.g. wage settlements higher than inflation due to incorrect anticipation of inflation imposes costs on employers and may lead to job losses

1958 Professor A.W. PhillipsExpressed a statistical relationship between the rate of growth of money wages and unemployment from 1861 1957Rate of growth of money wages linked to inflationary pressureLed to a theory expressing a trade-off between inflation and unemployment

Where the long run Phillips Curve cuts the horizontal axis would be the rate of unemployment at which inflation was constant the so-called Non-Accelerating Inflation Rate of Unemployment (NAIRU)To reduce unemployment to below the natural rate would necessitate: Influencing expectations persuading individuals that inflation was going to fall Boosting the supply side of the economy - increase capacity (pushing the PC curve outwards)Supply side policies have been focused on:Education: Boosting the number of those staying on at school Boosting numbers going to university Lifelong learning Vocational educationWelfare benefits: The working family tax credit Incentives to work Labour market flexibilityExpectations have been centred on: Operational independence of the Bank of England Tight control of public sector payThe independence of the Bank of England has taken away interest rate decision making from the government who may have been motivated by political ends this has had the effect of influencing expectations.

The Phillips CurveWage growth % (Inflation)Unemployment (%)An inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation. 1.5%6%4%PC13.0%PC2http://www.bized.co.ukCopyright 2007 Biz/edThe Phillips CurveInflationUnemploymentLong Run PCPC1PC2PC3Assume the economy starts with an inflation rate of 1% but very high unemployment at 7%. Government takes measures to reduce unemployment by an expansionary fiscal policy that pushes AD to the right (see the AD/AS diagram on slide 15) 7%2.0%1.0%There is a short term fall in unemployment but at a cost of higher inflation. Individuals now base their wage negotiations on expectations of higher inflation in the next period. If higher wages are granted then firms costs rise they start to shed labour and unemployment creeps back up to 7% again.3.0%To counter the rise in unemployment, government once again injects resources into the economy the result is a short-term fall in unemployment but higher inflation. This higher inflation fuels further expectation of higher inflation and so the process continues. The long run Phillips Curve is vertical at the natural rate of unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve.http://www.bized.co.ukCopyright 2007 Biz/edInflation and Unemployment using AS/ADInflationReal National IncomeAD1AS12%U = 4%Assume the economy has an inflation rate of 2% and a level of national income giving an unemployment rate of 4%. AD rises for some reason.AD2U = 3%3.75%The rise in AD leads to a fall in unemployment but inflationary pressures push inflation up to 3.75%. Producers try to expand output but at increased cost employing more expensive capital, paying workers more to do work etc. Increased cost results in a shift in AS to the left workers start to be laid off.AS24.0%The short run fall in unemployment is only temporary; as AS shifts, unemployment will start to rise again and the economy will end up in the long run in a position with unemployment at 4% but with higher inflation. Expansionary fiscal or monetary policy will only lead to reductions in unemployment in the short run. In the long run unemployment will return to its natural rate. Attempts to reduce unemployment below the natural rate will be inflationary.http://www.bized.co.ukCopyright 2007 Biz/edThe Phillips CurveWage growth % (Inflation)Unemployment (%)The Phillips Curve shows an inverse relationship between inflation and unemployment. It suggested that if governments wanted to reduce unemployment it had to accept higher inflation as a trade-off.Money illusion wage rates rising but individuals not factoring in inflation on real wage rates.1.5%6%4%2.5%PC1http://www.bized.co.ukCopyright 2007 Biz/ed