No Such Thing as a Free Lunch: Principles of Economics (Part 145)

Unemployment is an integral part of the normal capitalist system.

MICHAEL KALECKI

 The Labor Market, Unemployment, and Inflation (Part E)

by

Charles Lamson

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

If the AD curve shifts from year to year but the AS curve does not, the values of P and Y each year will lie along the AS curve [Figure 8 (a)]. The plot of the relationship between P and Y will be upward-sloping. Correspondingly, the plot of the relationship between the unemployment rate (which decreases with increased output) and the rate of inflation will be a curve that slopes downward. In other words, we would expect to see a negative relationship between the unemployment rate and the inflation rate.

If both the AS and the AD curves are shifting simultaneously, however, there is no systematic relationship between P and Y [Figure 8 (c)] and there's no systematic relationship between the unemployment rate and the inflation rate.

The Role of Import Prices One of the main factors that causes the AS curve to shift is the price of imports. (Remember, the AS curve shifts when input prices change, and input prices are affected by the price of imports, particularly the price of imported oil.)

Expectations and the Phillips Curve

If a firm expects other firms to raise their prices, the firm may raise the price of its own product. If all firms are behaving in this way then prices will rise because they are expected to rise. In this sense, expectations are self-fulfilling. Similarly, if inflation is expected to be high in the future, negotiated wages are likely to be higher than if inflation is expected to be low. Wage inflation is thus affected by expectations of future price inflation. Because wages are input costs (all the costs that go into producing a good or service), prices rise as firms respond to the higher wage costs. Previous expectations that affect wage contracts eventually affect prices themselves.

If the rate of inflation depends on expectations, then the Phillips Curve will shift as expectations change. For example, if inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. In this case, the Phillips Curve will shift to the right. If inflationary expectations decrease, the Phillips Curve will shift to the left---there will be less inflation at any given level of the unemployment rate.

Is There a Short-Run Trade-Off between Inflation and Unemployment?

There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves much more than simply choosing a point along a nice, smooth curve.

Recessions may be the price that the economy pays to eliminate inflation. We can now understand this statement better. When unemployment rises, other things being equal, inflation falls. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 567-569*

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