“Changes in the way economists have explained the relationship between inflation and unemployment have influenced the options available to governments with regard to pursuing a stabilising macroeconomic policy”. Explain this statement, identifying the major sources of disagreement amongst macroeconomists in this area? This essay analyses the different explanations of the relationship between inflation and unemployment. Before the concept of the Phillips Curve was introduced, Keynesians didn’t know how to adjust their model for taking into account inflation, referring to it as the ‘missing equation’.
In 1958 Alban W. Phillips conducted an empirical study analysing the unemployment and wage inflation data for Great Britain from 1861 to 1957. He found a strong negative correlation between money wage inflation and the rate of unemployment. These results were supported by similar findings in other countries. Figure 1 shows the negative relationship between money wage inflation and unemployment. This discovery implied the existence of a trade-off between these two important variables.
However this was only an empirical finding without any economic theory behind it, which is why it attracted a lot of interest in the scientific community. An economist that developed on this relationship was Richard G. Lipsey. The theory he offered came from deriving the Phillips Curve from the labour market disequilibrium. He starts his analysis with defining both sides of the labour market. The demand for labour DL =E+V, where E is the number of people employed and V is the number of vacancies and the supply side comprises of SL=E+U, where U is the number of people unemployed.
The difference between demand and supply is the excess demand for labour eDL=DL -SL or simply eDL=V-U. Figure 2 portrays the individual labour market. The money wage W is represented on the vertical axis. E0 is the point of initial equilibrium, where SL is equal to DL, therefore unemployment is zero. An increase in the labour demand (from DL0 to DL1), caused by let’s say an expansionary monetary policy, will lead to an excess demand for labour (E0 to A) at current money wage W0.
This will push the wages up to W1, establishing the new equilibrium at E1. Lipsey’s assumption was that dW/W=f [(DL-SL)/SL]. The graph of this function is represented in Figure 3. The speed of adjustment or the rate of change on wages dW/W is on the vertical axis and the excess demand for labour relative to the supply of labour [(DL-SL)/SL] on the horizontal axis. The further away we go from the origin the larger the excess demand for labour and the higher the speed of change of money wages.
As it was assumed that there is a strong inverse relationship between vacancies and unemployment, it will be enough to monitor just unemployment as it is a proxy for excess demand for labour. In Figure 4, the inverse relationship between recorded unemployment and excess demand for labour can be observed. Point B coincides with the equilibrium wage level W0 from Figure 1, where the excess demand is zero as well. The final diagram in Figure 5 represents the derived Phillips curve created by combining the assumptions made in Figures 3 and 4. It depicts the relationship between the unemployment and the wage change rates.