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Unemployment, NAIRU and the Phillips Curve - Activity

Nigel Lawson, the Chancellor of the Exchequer from 1983-89

The Phillips Curve outlines a possible relationship between inflation and unemployment. The inverse relationship suggests that there is a trade-off between inflation and unemployment. If lower employment is a goal then it can only be achieved at the cost of higher inflation.

The stagflation of the 1970s seemed to point to the death of the Phillips Curve, but a reassessment of the theory led economists to look at the role of expectations in decision-making. The 1980s saw Mrs Thatcher's government pursue monetarist policies that changed the economic landscape. The message was clear; inflation was the primary cause of unemployment and it needed to be defeated before the economy could grow and unemployment be reduced.

How relevant is the Phillips Curve to current economic policy? After all, the economy and the economic landscape has changed considerably in the last ten years. Is the Keynesian-Monetarist debate still relevant?

Image: Nigel Lawson, the Chancellor of the Exchequer from 1983-89. It was his experiments with monetarist policies that changed the way the economy was viewed, set the direction of policy for successive Conservative Governments into the '90s and, it could be argued, laid the foundations for the stability enjoyed in the late 1990s and into the 21st century - so far!
Title: Nigel Lawson. Copyright: Getty Images, available from Education Image Gallery

Task 1

It is important to understand the relationship between costs, aggregate supply and inflation to appreciate the basis of the Phillips Curve.

  1. Using the AD/AS model, explain what might happen to inflation if wage costs not associated with increases in productivity lead to inflation. (This, remember, was the basis of A.W. Phillips' research.)
  2. What difference would it make to your analysis if the wage increases were associated with increases in productivity?

We are now going to look at some data to see the extent to which there is a trade-off between unemployment and inflation. The data will not give you a nice neat curve that you might associate with the Phillips Curve. Instead, the data might jump all over the place! What you need to remember is that there might be a series of different Phillips Curves associated with different time periods. What you are looking for is the possibility of drawing in a 'line of best fit' for the data.

Task 2

  1. Go to Biz/ed's Key Economic Data section (http://www.bized.co.uk/dataserv/ked/index.htm) and select appropriate data to analyse the extent of the relationship between inflation and unemployment since 1994. Note the Phillips Curve charts the relationship between inflation and unemployment - the charts in the Key Economic Data section chart both of these against time. Therefore, you will have to use the data to plot the two against each other.
  2. Is your analysis any different if you chart wage increases against unemployment?
  3. Now go to the Office for National Statistics data on Biz/ed(http://www.bized.co.uk/dataserv/ons/data/data.htm) and go back further to assess the extent of the relationships between inflation and unemployment.
  4. As a result of your analysis, what conclusions can you draw about the accuracy of the Phillips Curve over the last 30 years?

Changes in the Phillips Curve might be explained by the role of expectations - what people think might happen in the economy. Expectations have become an important part of economic theory and have introduced further complications into the model. In essence, it builds in an assumption that people do not blindly react to past events ignoring the future; they make decisions based not only on what has happened in the past but also how that might affect events in the future. Rational expectations might assume that people base their expectations on rational thinking - if inflation was rising by an additional 0.5% over the last three years, it is safe to assume it will rise by an additional 0.5% next year! Daniel Kahneman(http://www.bized.co.uk/learn/economics/nobel/2002.htm), however, highlighted that rational expectation as a basis for economic decision making may be but one aspect in a person's thinking and that risk may be a key factor also.

Task 3

  1. There is plenty of data available for people to refer to to become informed in making decisions. What would be the key ways in which the average person might base their expectations of the future?
  2. How might such an expectations base differ for institutions such as foreign exchange markets, trades unions, government policy makers, financial institutions, industry and the Bank of England?

Finally:

  1. Having now spent some time analysing the Phillips Curve relationship, to what extent do you believe it contributes to economic policy-making in a modern economy?
  2. Given the falls in unemployment since the late 1980s, has the natural rate of unemployment been successfully reduced?

Additional resources

Extension work