Phillips Curve | RBI Grade B Phase 2 Preparation - Bank Exams PDF Download

 Page 1


 
 
UNIT 9   PHILLIPS CURVE
?
  
Structure 
9.0 Objectives 
9.1  Introduction 
9.2    Types of Unemployment 
9.3 Phillips Curve 
9.4 Natural Rate of Unemployment 
9.5 Expectations in Economics 
 9.5.1 Adaptive Expectations 
 9.5.2 Rational Expectations 
9.6 Expectation-Augmented Phillips Curve 
 9.6.1 Phillips Curve under Adaptive Expectations 
 9.6.2 Phillips Curve under Rational Expectations 
9.7 Let Us Sum Up 
9.8 Answers/ Hints to Check Your Progress Exercises 
9.0  OBJECTIVES 
After going through this unit you should be able to  
? identify various types of unemployment; 
? explain the concept of natural rate of unemployment; 
? establish a relationship between unemployment and inflation; 
? describe the concepts of adaptive and rational expectations; 
? explain how the short-run Phillips curve shifts; and 
? reconcile the difference in shape of the Phillips curve in short-run and long-
run. 
 
9.1 INTRODUCTION 
As you know from the previous two units, inflation is a situation where there is a 
general and sustained increase in prices of goods and services. With inflation, 
there is a decrease in the value of money and resultant decrease in the purchasing 
power of households. Increase in the rate of inflation also adversely affects the 
exchange rate. Inflation is caused by various factors that are concerned with 
demand and supply. Accordingly, inflation can be classified into two types – 
demand pull (caused by increase in demand) and cost push (cause by increase in 
cost of production). An important social issue, apart from inflation, is 
unemployment.  
                                                           
?
 Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi. 
Page 2


 
 
UNIT 9   PHILLIPS CURVE
?
  
Structure 
9.0 Objectives 
9.1  Introduction 
9.2    Types of Unemployment 
9.3 Phillips Curve 
9.4 Natural Rate of Unemployment 
9.5 Expectations in Economics 
 9.5.1 Adaptive Expectations 
 9.5.2 Rational Expectations 
9.6 Expectation-Augmented Phillips Curve 
 9.6.1 Phillips Curve under Adaptive Expectations 
 9.6.2 Phillips Curve under Rational Expectations 
9.7 Let Us Sum Up 
9.8 Answers/ Hints to Check Your Progress Exercises 
9.0  OBJECTIVES 
After going through this unit you should be able to  
? identify various types of unemployment; 
? explain the concept of natural rate of unemployment; 
? establish a relationship between unemployment and inflation; 
? describe the concepts of adaptive and rational expectations; 
? explain how the short-run Phillips curve shifts; and 
? reconcile the difference in shape of the Phillips curve in short-run and long-
run. 
 
9.1 INTRODUCTION 
As you know from the previous two units, inflation is a situation where there is a 
general and sustained increase in prices of goods and services. With inflation, 
there is a decrease in the value of money and resultant decrease in the purchasing 
power of households. Increase in the rate of inflation also adversely affects the 
exchange rate. Inflation is caused by various factors that are concerned with 
demand and supply. Accordingly, inflation can be classified into two types – 
demand pull (caused by increase in demand) and cost push (cause by increase in 
cost of production). An important social issue, apart from inflation, is 
unemployment.  
                                                           
?
 Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi. 
 
   93 
 
Phillips Curve 
It has economic implications for people – unemployment is a situation where a 
healthy person, who is willing to work, fails to get employment at the prevailing 
wage. It not only results in loss of income to the family, it puts the person’s 
morale down. At the aggregative level, it results in a loss of valuable human 
resources – the services of the unemployed persons could have been productively 
utilized in the production of goods and services. In fact, inflation and 
unemployment are considered to be two important evils of society. Social 
implications of inflation and unemployment are far more serious. These problems 
could lead to social stress and political instability in a country. 
Economists have long been intrigued by the relationship between inflation and 
unemployment. Recall that the classical economists advocated independence of 
real sector from the monetary sector. While unemployment is a real variable, 
inflation pertains to the monetary sector. Thus classical economists could not 
visualise a relationship between inflation and unemployment. According to the 
classical economists, an increase in money supply will lead to an increase in 
price level (refer to the quantity theory of money), leaving behind the level of 
output unchanged. The assumption of flexibility in wage rate ruled out the 
possibility of a person being unemployed. Thus, the classical economists never 
thought of unemployment as a problem; they believed it to be a transitory issue. 
Keynes, on the other hand, suggested that monetary variables have real 
implications. The transmission mechanism suggested by him is as follows: As 
money supply increases, there is a decline in the rate of interest. Lower interest 
rate leads to an increase in investment. An increase investment leads to an 
increase in employment and output.    
As you know from microeconomics, labour is demanded by firms as it 
contributes to production of goods and services. In return of its contribution, 
labour is rewarded with wages. In the labour market, equilibrium wage rate is 
determined at a level where the supply of labour is equal to the demand for 
labour. While human beings supply more labour at higher wage rate, firms 
demand lower quantity of labour when wage rate is high. Thus supply of labour 
has a positive relationship with wage rate (implying upward sloping supply 
curve) while demand for labour has a negative relationship with wage rate 
(implying downward sloping demand curve). 
In this Unit we will consider the relationship between inflation and 
unemployment, given by the Phillips curve. We will analyse the difference in the 
shape of the Phillips curve between short run and long run.  
 
9.2  TYPES OF UNEMPLOYMENT 
‘Labour force’ as a concept includes all persons in the age group of 16 years to 
64 years who are willing to work. Thus it includes both employed and 
unemployed persons. The persons not included in the labour force include those 
who are retired, too ill to work, keeping the house, or simply not looking for 
work.  
Page 3


 
 
UNIT 9   PHILLIPS CURVE
?
  
Structure 
9.0 Objectives 
9.1  Introduction 
9.2    Types of Unemployment 
9.3 Phillips Curve 
9.4 Natural Rate of Unemployment 
9.5 Expectations in Economics 
 9.5.1 Adaptive Expectations 
 9.5.2 Rational Expectations 
9.6 Expectation-Augmented Phillips Curve 
 9.6.1 Phillips Curve under Adaptive Expectations 
 9.6.2 Phillips Curve under Rational Expectations 
9.7 Let Us Sum Up 
9.8 Answers/ Hints to Check Your Progress Exercises 
9.0  OBJECTIVES 
After going through this unit you should be able to  
? identify various types of unemployment; 
? explain the concept of natural rate of unemployment; 
? establish a relationship between unemployment and inflation; 
? describe the concepts of adaptive and rational expectations; 
? explain how the short-run Phillips curve shifts; and 
? reconcile the difference in shape of the Phillips curve in short-run and long-
run. 
 
9.1 INTRODUCTION 
As you know from the previous two units, inflation is a situation where there is a 
general and sustained increase in prices of goods and services. With inflation, 
there is a decrease in the value of money and resultant decrease in the purchasing 
power of households. Increase in the rate of inflation also adversely affects the 
exchange rate. Inflation is caused by various factors that are concerned with 
demand and supply. Accordingly, inflation can be classified into two types – 
demand pull (caused by increase in demand) and cost push (cause by increase in 
cost of production). An important social issue, apart from inflation, is 
unemployment.  
                                                           
?
 Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi. 
 
   93 
 
Phillips Curve 
It has economic implications for people – unemployment is a situation where a 
healthy person, who is willing to work, fails to get employment at the prevailing 
wage. It not only results in loss of income to the family, it puts the person’s 
morale down. At the aggregative level, it results in a loss of valuable human 
resources – the services of the unemployed persons could have been productively 
utilized in the production of goods and services. In fact, inflation and 
unemployment are considered to be two important evils of society. Social 
implications of inflation and unemployment are far more serious. These problems 
could lead to social stress and political instability in a country. 
Economists have long been intrigued by the relationship between inflation and 
unemployment. Recall that the classical economists advocated independence of 
real sector from the monetary sector. While unemployment is a real variable, 
inflation pertains to the monetary sector. Thus classical economists could not 
visualise a relationship between inflation and unemployment. According to the 
classical economists, an increase in money supply will lead to an increase in 
price level (refer to the quantity theory of money), leaving behind the level of 
output unchanged. The assumption of flexibility in wage rate ruled out the 
possibility of a person being unemployed. Thus, the classical economists never 
thought of unemployment as a problem; they believed it to be a transitory issue. 
Keynes, on the other hand, suggested that monetary variables have real 
implications. The transmission mechanism suggested by him is as follows: As 
money supply increases, there is a decline in the rate of interest. Lower interest 
rate leads to an increase in investment. An increase investment leads to an 
increase in employment and output.    
As you know from microeconomics, labour is demanded by firms as it 
contributes to production of goods and services. In return of its contribution, 
labour is rewarded with wages. In the labour market, equilibrium wage rate is 
determined at a level where the supply of labour is equal to the demand for 
labour. While human beings supply more labour at higher wage rate, firms 
demand lower quantity of labour when wage rate is high. Thus supply of labour 
has a positive relationship with wage rate (implying upward sloping supply 
curve) while demand for labour has a negative relationship with wage rate 
(implying downward sloping demand curve). 
In this Unit we will consider the relationship between inflation and 
unemployment, given by the Phillips curve. We will analyse the difference in the 
shape of the Phillips curve between short run and long run.  
 
9.2  TYPES OF UNEMPLOYMENT 
‘Labour force’ as a concept includes all persons in the age group of 16 years to 
64 years who are willing to work. Thus it includes both employed and 
unemployed persons. The persons not included in the labour force include those 
who are retired, too ill to work, keeping the house, or simply not looking for 
work.  
 
94 
 
Inflation and 
Unemployment 
‘Work force’ as a concept is somewhat narrower – it includes the employed 
persons only. Thus the difference between the labour force and the work force 
gives us the number of unemployed.  
By employed persons we mean those who perform any paid work (thus 
homemakers are not included) and those who have jobs. On the other hand, the 
unemployed as a category includes people who are not employed but are actively 
looking for work. While considering unemployment we do not take into account 
those who are not in the labour force. We define unemployment rate as the 
number of unemployed divided by the total labour force. You should remember 
that the concept of unemployment implies ‘involuntary unemployment’. This 
concept implies that a person is willing to work at the prevailing wage rate, but 
cannot find work.    
There are three types of unemployment, viz., frictional, structural and cyclical. 
We explain the differences below. 
(i) Frictional unemployment: It takes place because people switch over from one 
job to another. In many cases the tenure of job gets over and workers remain 
unemployed till they get another job. In other cases workers migrate from one 
region to another in search of better jobs or opt to remain out of job for short time 
periods. Frictional unemployment takes place because in an economy with 
imperfect information, job search and matching is not smooth and there are 
frictions in the economy.  
(ii) Structural unemployment: It results from the mismatch between supply and 
demand for different kinds of jobs. For example, in recent years, the number of 
engineers and management professionals looking for jobs in India has been much 
higher than available jobs. This has resulted in a number of persons with 
technical qualification opting for low qualification jobs. Structural 
unemployment takes place largely due to structural shifts in an economy and 
adjustments to such shifts take time. A large number of educational institutions in 
India have discontinued their engineering education programmes. 
(iii) Cyclical unemployment: It arises due to fluctuations in aggregate demand, 
which is a part of business cycles. When aggregate demand declines, there is 
simultaneous decline in the demand for labour and consequent increase in 
unemployment. On the other hand, a general boom in the economy increases the 
demand for labour and unemployment decreases. Thus cyclical unemployment is 
pro-cyclical in nature.  
Empirical data shows that the labour force in an economy is much less than the 
total population. Total labour force in India, according to certain sources, is about 
50 crores compared to an estimated population of 138 crores in 2020. Persons 
above 65 years and children below 15 years of age however should not be taken 
into consideration while comparing the size of the labour force to total 
population. A relevant ratio in this context is the ‘Labour Force Participation 
Rate (LFPR)’. It is defined as follows: