Figure 3.1 The Phillips’ curve

0

1

2

3

4

5

6

7

8

2

4

6

8

10

12

Inflation

A

B

C

 

As you can see in Figure ‘ The Phillips’ curve’, the vertical axis represents the unemployment rate, and the horizontal axis represents the rate of inflation. You can also see that the lower the rate of inflation, the higher the unemployment rate, and vice versa. For example, according to the information contained in the graph, with inflation running at a low 1.75 percent annual rate, unemployment would be 8 percent. With inflation at 3 percent, unemployment would be reduced to 4 percent. Double the inflation rate again (to 6 percent), and unemployment would be reduced to 2 percent.

But something happened in the late 1970s and early 1980s that led economists to question the reliability of Phillips’ curves. The economy was stagnant and suffering from relatively high rates of inflation and unemployment. For example, in 1979 with inflation running at an annual rate of 11 percent, unemployment stood at about 5.75 percent of the labor force in the USA. The following year the inflation rate rose to 13 percent, but instead of falling, the unemployment rate rose to 7 percent.

Economists are still debating the value of the Phillips’ curve. Those who see it as a useful tool for understanding the economy point to the successful effort of the Reagan Administration to reduce inflation in the early 1980s. It was government’s willingness to push unemployment to record levels that finally brought inflation under control. Those who disagree say that while the Phillips’ curve provides an interesting picture of past history, it should not be used to design economic policies for the future.

Clearly, it is desirable to reduce unemployment and inflation. Unemployment represents a lost opportunity for workers to engage in productive effort—and to earn income. Inflation erodes the value of money people hold, and more importantly, the threat of inflation adds to uncertainty and makes people less willing to save and firms less willing to invest. If there were a trade-off between the two, we could reduce the rate of inflation or the rate of unemployment, but not both.

The Phillips curve seemed to make good theoretical sense. The dominant school of economic thought in the 1960s suggested that the economy was likely to experience either a recessionary or an inflationary gap. An economy with a recessionary gap would have high unemployment and little or no inflation. An economy with an inflationary gap would have very little unemployment and a higher rate of inflation. The Phillips curve suggested a smooth transition between the two. As expansionary policies were undertaken to move the economy out of a recessionary gap, unemployment would fall and inflation would rise. Policies to correct an inflationary gap would bring down the inflation rate, but at a cost of higher unemployment.

 

Key concepts

· The view that there is a trade-off between inflation and unemployment is expressed by a Phillips curve.

· While there are periods in which a trade-off between inflation and unemployment exists, the actual relationship between these variables may be a more difficult to identify.

· In a Phillips phase, the inflation rate rises and unemployment falls. A stagflation phase is marked by rising unemployment while inflation remains high. In a recovery phase, inflation and unemployment both fall.

 

Unit 1.6 Price Indexes

Learning objectives

Explain what a price index is and outline the general steps in computing a price index.

Describe and compare different price indexes.

Explain how to convert nominal values to real values and explain why it is useful to make this calculation.

4. Discuss the biases that may arise from price indexes that employ fixed market baskets of goods and services.

Price Indexes

Economists measure the price level with a price index. A price index is a number whose movement reflects movement in the average level of prices. If a price index rises 10%, it means the average level of prices has risen 10%.

There are four steps one must take in computing a price index:

1. Select the kinds and quantities of goods and services to be included in the index. A list of these goods and services, and the quantities of each, is the ‘ market basket ’ for the index.

2. Determine what it would cost to buy the goods and services in the market basket in some period that is the base period for the index. A base period is a time period against which costs of the market basket in other periods will be compared in computing a price index. Most often, the base period for an index is a single year.

3. Compute the cost of the market basket in the current period.

4. Compute the price index. It equals the current cost divided by the base-period cost of the market basket.

Price index = current cost of basket / base-period cost of basket

While published price indexes are typically reported with this number multiplied by 100, our work with indexes will be simplified by omitting this step.