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Monetary Policy - Inflation - Causes

Worksheet 3 - Is inflation inevitable - the Phillips curve?

This worksheet deals with the relationship between unemployment and inflation as established by Professor A.W. Phillips. It considers whether the Phillips curve still exists and is therefore still relevant to policy-makers.

1. On the axes below draw a curve to show the original relationship between unemployment and inflation that Professor Phillips observed. You can find details of the Phillips curve in the theory section.

(2 Marks)

2. The link between unemployment and inflation has good theoretical backing behind it. Delete words in bold as appropriate in the paragraph below, to show the relationship between unemployment and inflation.

If the economy has just been in recession, then unemployment will tend to be fairly high / low. This will mean that there is a surplus / shortage of labour. As the economy grows, aggregate demand will increase / decrease and this will lead to an increase / decrease in employment. At first there will be little pressure on wages to rise / fall, but as the economy starts to grow faster and more / less people are employed, wages will eventually rise / fall. This will increase / decrease firms' costs and they will tend to pass this on in higher / lower prices.

Therefore a(n) increase / decrease in unemployment has led to a(n) increase / decrease in inflation - a Phillips curve relationship.

(11 Marks)

3. Around when did the Phillips curve relationship begin to breakdown?

(1 Mark)

4. The breakdown of the Phillips curve was caused by stagflation. What is meant by stagflation? (You may find the glossary useful for this)

(2 Marks)

5. Some economists have argued that the Phillips curve relationship between unemployment and inflation has returned in more recent years. To test this, go to the data section and collect the data needed to fill in the table below (Alternatively you could download the data to a spreadsheet package). You will need to use the following variables:

• CZBH UK Retail prices all goods and services
• BCJD UK Claimant count unemployment

Use this data to plot points on the axes below to see if there is a Phillips curve relationship. Each year should be one point which shows the level of unemployment and inflation for that year. You could join the points together in order to show the way the levels of unemployment and inflation have changed over the years. (If doing it in a spreadsheet use the scatter graph option to draw this.)

(5 Marks)

6. Is there any evidence of the Phillips curve having returned? (Refer precisely to the data in your answer)

(4 Marks)

7. The breakdown of the Phillips curve caused some economists to re-examine the relationship between unemployment and inflation. Milton Friedman argued that there was a series of Phillips curves, all for different levels of price expectations. He called this the 'expectations-augmented Phillips curve'. Use the theory section to find out more about this, and answer the questions below.

What is meant by the 'natural rate of unemployment'?

(2 Marks)

8. What will happen if the government try to reduce unemployment below the natural rate?

(4 marks)

9. Look again at the graph you drew above. Is there any evidence of an expectations-augmented Phillips curve? Explain your reasoning.

(5 Marks)

10. To test the various Phillips curve theories more fully, what further information might you need to know?

(5 Marks)

Total Marks = 41